Potential Small Business Red Flags That Can Trigger IRS Audits

The IRS recently announced that it plans to increase oversight and auditing of small business taxes, as it believe that small business underreporting is responsible for 84% of the IRS’s projected $450 billion tax gap.

The IRS identified seven specific areas it plans to focus on when reviewing and auditing small business and small business owners; many of these areas are ones entrepreneurs and startup owners should pay particular attention to in their own businesses:

1) High income: In 2011 the IRS audited 12.5% of taxpayers with incomes over $1 million. Though this won’t apply to most entrepreneurs, it may apply to those whose companies are now taking off and that utilize pass-through taxation (e.g.: disregarded entity, partnership, or subchapter S).

2) International funds and transactions: Another area that is unlikely to apply to most entrepreneurs is focusing on the transfers of funds overseas and international transactions, although if a startup has appreciable business in a neighboring country such as Canada or Mexico (or elsewhere) they may want to ensure that they are meeting their tax obligations here in the US.

3) Partnerships: For the first time the IRS is beginning to look at partnerships that incur large losses, so if your startup is organized as or taxed like a partnership, you may want to ensure that your accounting is in order.

4) S Corporations: The IRS will be looking to ensure that deductions made by S-corps are proper, and more importantly that distributions and dividends are not being used to avoid Social Security/Medicare and payroll taxes. Make sure that you are paying equity holders who work in the company a reasonable wage or salary, or that at least there is a reasonable balance between wage/salary and dividends/distributions.

5) Fringe benefits: Most employee fringe benefits must be reported as income (and are therefore usually subject to payroll taxes). Make sure that you are properly accounting for all taxable benefits you provide to your employees.

6) Small business employee health insurance credit: Small businesses receive tax credits for providing health insurance to employees. The IRS will be checking to ensure that small business qualify for and are properly calculating the credit.

7) Worker classification: The IRS believe there is significant misclassification by small businesses of workers as independent contractors, and will be looking to make sure that small businesses are not abusing the classification to avoid payroll taxes.

Even if you do your startup’s taxes in-house, you should at least have a CPA or tax attorney you can contact in the event you have questions or need clarification. And in the event you are audited by the IRS, you should retain a tax attorney to help guide and protect you through the auditing process.