Tax Audit Red Flags – What Triggers an Audit and How to Avoid Them
No matter if you run a convenience store, restaurant, car service, beauty salon or cannabis dispensary; the IRS will look out for businesses which appear to be bringing in more cash than they’re spending – this could result in an audit being performed on them.
Errors and inconsistencies are major warning signs, increasing audit risk by claiming unexpectedly large deductions one year followed by smaller ones the next.
Missing Income
No one wants a notice from the IRS, particularly small business owners. An audit can be time consuming and expensive; thus it’s essential that business owners avoid common errors that could trigger an IRS investigation.
Cash-based businesses such as juice bars or taxi services run the risk of an audit more easily than their cash counterparts, such as with payments being difficult to track. It is advised to form an LLC or other type of corporation in such instances for improved efficiency.
Similarly, having outstanding tax liabilities from prior years can signal an audit. To prevent an audit from taking place and ensure accuracy in filing taxes and avoid rounding or other mistakes that are easily detected by IRS reviewers. You should have an accountant keep an eye on your finances to make sure you’re following all regulations.
Large Cash Payments
Large cash payments are an audit red flag. The IRS takes notice when returns report large cash earnings because cash can be hard to track, providing taxpayers with an easy way to conceal income or avoid taxes altogether. Therefore, the IRS has taken notice and taken actions against cash-based businesses like restaurants and convenience stores as well as taxi drivers collecting off-meter fares or selling merchandise without reporting.
The IRS scrutinizes returns that claim significant mortgage interest deductions or charitable donations. Overestimating expenses, making math mistakes or failing to sign your return are also red flags that could prompt an IRS examination of your return. While chances of an audit are relatively low, you should still prepare your returns correctly so as to prevent an audit in 2023. Keeping good records and avoiding mistakes are some ways that could help.
Inconsistencies in Your Tax Returns
As Benjamin Franklin famously noted, only death and taxes can be guaranteed in life. For US expats residing overseas, accurate tax filing is vital if they wish to remain compliant with both US and their country of residence tax regulations; submission of inaccurate returns could trigger IRS scrutiny leading to costly penalties.
Some taxpayers may be more susceptible to audits than others, particularly those with higher incomes and/or more aggressive deductions. As a general guideline, any significant variations between years could alert the IRS of potential issues in your return and potentially trigger an audit.
Rounding expenses to the nearest dollar may seem questionable, and making significant deductions without sufficient documentation (such as travel writing, beer brewing or horse racing). Schedule C businesses with significant losses may also be subject to scrutiny for profit motivation purposes; overstating charitable donations is often used as a trigger in audits while reporting large deductions for meals and entertainment without appropriate paperwork may also invite scrutiny.
Changes in Your Income
If your income or deductions have dramatically changed from last year, or are wildly dissimilar from what was filed last time, this will raise suspicion with the IRS. Unexpected charitable donations or expenses should also raise an eyebrow. Furthermore, they may focus on industries using large sums of cash – like car dealerships, restaurants, laundromats, storage units bed and breakfasts or import/export companies that utilize this capital intensively.
Another red flag for businesses that seem to be experiencing more losses than profits is when their losses outstrip profits. According to the IRS’ three-of-five-year rule, businesses must show profits within three of five years before being considered profitable. Furthermore, the IRS scrutinises businesses that utilize independent contractors too heavily as it’s essential they classify workers correctly in order to avoid being hit with large back payroll taxes and penalties; seeking professional tax help is an invaluable way to make sure taxes are filed correctly and accurately.
