Red Flags to Avoid an IRS Audit

Small business owners are some of the world’s busiest people.  Keeping up with operations, sales, service and running the company can feel like a never-ending process.  An audit can significantly add to the stress and workload of small companies, so it’s important to maintain general standards to avoid being selected for an audit.  

Generally, the IRS can go back three years for an audit.  However, if some significant errors occur on tax returns, it allows the IRS to go back another few years.  Below are some red flags that will increase your chance of an audit. 

Not Reporting All Taxable Income

You must report all 1099s and W-2s.  Remember, the IRS gets copies of all the 1099s and W-2s you receive.  So, the IRS will find out if you overlook any taxable income.  

Deducting Business Meals, Travel and Entertainment

The new tax law did away with the deduction for entertainment expenses.  However, there are a few exceptions including: 

  • Entertainment treated as compensation on your originally filed tax returns (and treated as wages to your employees).
  • Recreational expenses for employees, such as a holiday party or a summer picnic. 
  • Expenses related to attending business meetings or conventions of certain exempt organizations such as business leagues, chambers of commerce, professional associations, etc.
  • Entertainment sold to customers. For example, if you run a nightclub, your expenses for the entertainment you furnish to your customers, such as a floor show, are not subject to the nondeductible rules.

For more detailed information on what is deductible and non-deductible for this category, please refer to IRS Publication 463 – Travel, Gift and Car Expenses. 

Claiming 100% Business Use of a Vehicle 

Keep a log on the dashboard and write down every mile for work, the date, and what it was for.  If you do claim all cost for a business expense, be sure that vehicle is used strictly for your business and have another vehicle for your personal use. 

Hiring a Preparer Who Falsifies Your Return — Without Your Knowledge 

Incompetent or unethical tax preparers can cost money and time. Should the IRS see a pattern of problems on returns coming from one preparer, they may flag the entire operation’s returns for that year or the past several years. 

If an egregious error is discovered, it is likely to be on you — not the tax preparer. 

Writing Off a Loss for a Hobby 

Businesses are meant to be profitable. If you report losses for at least three of the past five years, your “business” is more likely to be viewed as a hobby by the IRS.  This will be a red flag to the IRS because the IRS disallows any business deductions for hobbies that you may try to claim on your Schedule C. 

Remember, if you are facing an audit, you need solid documentation to back up your claims.  Keep all information used to prepare your tax return for at least three years. 

It is almost tax season and if you are not sure of what can be claimed on your tax returns, always refer to the IRS website – At the UMW SBDC, we have compiled a list of local resources, including accountants, in our resource page.