The 8 Most Common Tax Audit Triggers

Most small-business owners would say one thing they would meticulously avoid if given the chance is a tax audit. But rather than living in fear of the unknown, let’s take a look at some of the most common triggers for a small-business tax audit. The IRS uses a computer program called the Discriminate Function System (DIF) that analyzes returns and flags them if they are outside statistical norms. When a return receives a high DIF score, an agent reviews it to determine if it should undergo an audit. Luckily, there are some common areas known to trigger flags and audits on small-business tax returns — and if you avoid them on your returns, your odds of an audit will likely be reduced. Here are eight areas you should pay special attention to when filing your small business taxes.
1. Having a Higher Than Average Income According to an AP story, just 0.9 percent of people who make less than $200,000 were audited last year, compared to 10.9 percent of those who made $1 million or more. With the substantially increased odds of an audit for higher income brackets, you’ll need to keep meticulous financial records in case y¬¬¬ou get the call.

2. Out of Proportion Deductions
Large deductions that reduce the amount of your taxable income may raise a flag if they are out of proportion with your income. The IRS uses tables to determine how much is too much for different income brackets when it comes to deductions, although the tables are not made public. For example, an IRS agent will want to know more if you claim charitable deductions that are not in line with your income. In addition, a small business that has a low income will create a flag if its deductions are larger than normal for that income range. Sometimes those lopsided deductions are legitimate — such as when first starting a business or during lean years. You should absolutely take the deductions that you’re entitled to, but be sure you have detailed records to back them up.

3. Numbers That Have Been Rounded or Averaged
Rounding up or averaging numbers in everyday life might be acceptable, but when it comes to your tax return, it can trigger an audit.  If you made $60,002.36 last year, don’t report your income as $60,000 or you may find yourself sitting across the desk from an IRS agent. They tend to believe that if you’re sloppy in this area, the rest of your return may not be entirely accurate.

4. Home Office Deductions
Last year, the IRS simplified the home office deduction method, but the requirements necessary to take it have not relaxed. You can still only claim a portion of your home if it is exclusively dedicated to your business. For instance, if you use a corner of your bedroom, it won’t qualify for the deduction because the room is used for personal use as well.

5. Claiming Business Losses Year After Year
The IRS will take notice if you claim that your business is taking a loss year after year, and may initiate an audit. They know some people claim hobby expenses as business losses, and under the tax code, that’s illegal. If you run a legitimate business that continuously reports a loss, the IRS may assume you are taking deductions you’re not entitled to in order to avoid paying taxes. But some business owners do experience a few bad years, and can clear up the matter by first proving that their business is legitimate, and then justifying the deductions with their records.

6. Filing a Schedule C
The schedule C is where small-business owners can take the deductions that will lower their taxable income, and many people believe that filing one will increase the chances of an audit. The IRS does scrutinize these types of returns more closely. Don’t let fear of an audit keep you from claiming legal deductions. Just make sure that you have careful documentation to justify all of them. If you don’t want to file a schedule C, you can set up your business as a separate entity and run all of the business expenses through it.

7. Excessive Deductions for Business Entertainment
Everyone has heard stories about business owners taking a family trip to Hawaii, and then writing it off as a business expense. Or about the business owner who continually takes friends out to eat, and then writes off the expense on their taxes. Unfortunately for those people, the IRS has heard the same stories. If a tax return includes higher-than-average entertainment expenses, it will set off an alarm with the IRS and increase the chances of an audit. If you’re going to deduct these types of expenses, you must keep records for each write-off that includes when and where it occurred, who was in attendance, the purpose as it relates to your business, and a record of what was talked about. You’ll also need to keep receipts for expenses greater than $75 when you’re traveling for business.

8. Claiming Your Vehicle As 100 Percent Business Use
When deducting for business use of a car, you’ll have to choose between the IRS standard mileage rate and actual expenses. Deducting both of these on your tax return will bring the IRS knocking. In addition, if you claim 100 percent business use on the depreciation form for your vehicle, you’ll need precise records that include mileage logs, dates, and the purpose of every trip.

Now for the good news. In the same AP story mentioned above, the new IRS Commissioner John Koskinen said that last year less than 1 percent of all returns underwent an audit, and he predicts that with the recent budget cuts, this year could be even fewer. (Only 0.6 percent of business returns were audited.) Still, it’s a good idea to take heed of the common audit triggers listed here, and if you want to put your mind more at ease, head on over to Kiplinger, which offers a free tax audit risk calculator.