A Business Owner's Guide to IRS Audit Red Flags

Sooner or later, most small business owners can expect a tax audit. An IRS audit is probably the most stressful thing business owners can imagine. They might seem to come out of thin air, but your business expenses can trigger extra scrutiny from the IRS agents reviewing your returns.

Not all expenses are deductible, and not everything you spend on your business is a business expense. Excessive deductions will always stand out on your returns, even if they are legitimate costs. If you understand the red flags the IRS looks for, you can better avoid catching its eye.

Operating a business with high audit risks, such as numerous cash transactions, significant deductions, or operating at a net loss, can increase your likelihood of being audited. If you do attract the attention of an IRS auditor, you can still defend your deductions as legitimate business expenses. The guidelines in this article will explain what business deductions to avoid and what to do if you get a Notice of Audit in the mail.

Common Red Flags That Trigger IRS Scrutiny

Not all business expenses are legitimate deductions. While the internet contains many “helpful” tips, there’s no guarantee they’re either correct or legal. Some of the most common deductions have become IRS red flags that auditors look for on your tax returns. With proper documentation, you can limit many of these triggers.

Under the Tax Cuts and Jobs Act (TCJA), only self-employed business owners can claim business deductions on their income tax returns. Employees cannot claim out-of-pocket expenses as tax deductions.

Red Flag No. 1: Home Office Deductions

The rise of work-from-home and remote work has led to an increase in attempts to deduct daily expenses for “business purposes.” The home office deduction is often misunderstood, leading to ill-advised tax declarations.

A home office must meet the “exclusive use” test. This is a common audit trigger that will cause IRS scrutiny. You must use the area “regularly and exclusively” for business purposes only. Any personal use invalidates the business purpose. If you set down your laptop and turn on the TV, the space does not meet the “exclusive use” test.

If you only use the home office for work, you can take a business deduction for the percentage of space the office uses in the house. You can deduct:

• Rent/mortgage
• Utilities
• Property tax and insurance
• Household and office supplies

It’s a good idea to have a separate bank account and pay for expenses from your business income.

Red Flag No. 2: Vehicle and Travel Expenses

You can deduct ordinary and necessary expenses, including costs for your vehicle and travel, if they are necessary for your business. For audit purposes, travel expenses include long-distance travel, not a trip to the local grocery store. If the purpose of your business requires traveling, then it may qualify.

You must keep a detailed mileage log and report it on your Schedule C when you file your taxes. A tax preparation professional or tax attorney can explain what self-employed individuals need to have for their deductions. If you need to repair your work vehicle and want to deduct the costs, you’ll need supporting documents showing how it’s necessary for your job.

Red Flag No. 3: Meals and Entertainment

The days of taking your best clients out for dinner and being able to write off the cost are long gone. You must clearly document the business purpose of a meal and can only claim up to 50% on your taxes. Company events are 100% deductible, but they must have a clear employee-related purpose and benefit. These include company retreats and award ceremonies.

All costs and expenses must relate to the business purpose. If you fly to Vermont for a ski vacation and take a quick side trip to New York to close a contract, you cannot deduct the whole trip.

Red Flag No. 4: Too Much Miscellany

Too many miscellaneous expenses, or some large uncategorized expenses, will put you on the IRS’s radar. Some taxpayers try to dodge their taxes with the “uncategorized” category, which rarely works. If you’re not sure where a deduction ought to go, ask your tax attorney or CPA.

Some miscellaneous expenses aren’t legitimate deductions and won’t be approved by the IRS. They can include:

• Capital expenditures: These are purchases of equipment, vehicles, buildings, and other things that will benefit your business. Startup costs are deductible, but not all expenses afterward.
• Political contributions: Sole proprietors can donate to whatever candidate they wish, but they cannot deduct the contribution. Charitable contributions must also remain on your personal return.
• Business gifts: The IRS puts limits on your generosity. Anything over $25 per person per year is not deductible.
• Fines, penalties, and legal fees: Some legal fees can be deductible if they relate to operating the business. Most are not. Ask your tax attorney if you aren’t sure.
• Life insurance premiums: These are deductible only if your business pays for all your employees’ coverage. If you don’t have any employees, talk to your tax attorney or insurance adjuster.

Any of these red flags could cause the IRS to take a second look at your tax returns. The IRS also performs random audits from a selection of individual and business tax returns in a given area.

When Personal and Business Expenses Collide

Small business owners and self-employed business people can find it very difficult to keep their personal and business accounts separate. Full-time operation of a home and business means you may need money for one and have to take it from the other. That isn’t necessarily illegal, but it can cause you major headaches at tax time.

When the IRS thinks you’ve been combining (commingling) your personal and business accounts, they can take a much closer look at both types of accounts. A business owner who combines personal and business expenses risks their limited liability protection. Attorneys call this “piercing the corporate veil,” where a business owner is held personally liable for business debts and obligations.

The best way to avoid this trap is by keeping separate bank accounts and credit cards for your business and personal expenses. There are ways to cover business losses with personal funds, but you should not do so without consulting a business tax professional.

What Happens When You Get Audited

Even if you do your best, you could still get a notice from the IRS. Discrepancies in the tax return or math errors in your supplemental forms could catch the eye of an auditor. Don’t panic. Things aren’t as bad as you may think.

Step One: Notice of Audit

The IRS will always send you a letter notifying you of an upcoming audit. You will never receive a phone call or text message, at least not initially. Typical notices include Letter 566/566D (Notice of Initial Contact) or CP75/CP75A Request for Supporting Documentation. This notice asks for additional documents to verify the deductions you claimed on your Schedule C.

Step Two: Contact the IRS

There is a date on the letter. Make a note of it, because it is essential that you contact the IRS by that date. The IRS must hear from you by that date, or you could be subject to additional fines and penalties. Do not ignore the notice and hope it will go away. Many business owners get into trouble by failing to respond in a timely manner.

Step Three: Contact a Tax Attorney

You can reverse Steps Two and Three. You should discuss your options with a tax attorney, especially if the IRS is auditing you for more than one tax year. It’s also a good idea if they requested a large number of documents.

Step Four: Prepare for the Interview

The IRS conducts audits by mail or in-person. The most common method is to ask you to mail the supporting documents. They will accept some documents via online submission, but they cannot accept all types of documentation this way.

Once they review the additional documents and amended tax returns, they will make a recommendation. This may mean no change to your return, an agreed-on assessment, or a decision you disagree with and can appeal.

Your Defense: The Power of “Ordinary and Necessary”

In many cases, a business’s IRS audit hinges on whether its claimed deductions have a legitimate business use. For IRS purposes, “ordinary and necessary” business expenses must be both:

• Common and accepted in the taxpayer’s trade or business
• Helpful and appropriate, although not indispensable, for business operations

For example, advertising materials like cheap pens with the company logo are “ordinary and necessary” because most companies use them. Diamond necklaces made in the image of the company logo are not.

Capital expenses are not considered “ordinary and necessary.” Depreciation provides deductions for fixed assets.

The best way to establish ordinary and necessary expenses is through detailed records and experienced legal representation. Assuming you have good recordkeeping and provided receipts with your tax return and Schedule C, the IRS needs to see how these outlays are common and appropriate to your business.

For example, consider a local plumbing business with four trucks. The owner drives one of the trucks and works as a plumber four days a week. During the audit and request for documents, the attorney can help show:

• Other plumber-owners regularly work four or five days per week, and drive a similar number of miles per day. This is ordinary and necessary in the plumbing business.
• Other plumbing vehicles regularly travel this many hours and require this amount of maintenance. Maintenance in the owner’s area averages a certain amount per hour, plus parts.
• This owner works out of a small office in the back of his house. The owner correctly accounted for the office’s percentage and calculated utilities accordingly.
• After filing his taxes, the plumber-owner discovered that his son had used the office computer to join an online video tournament. The owner filed an amended return reflecting this and paying the corrected taxes before the Notice of Audit arrived.

Having an attorney who could explain this to the IRS auditor would help the plumber avoid paying penalties for misreporting the business taxes and a potential charge for underpaying the household taxes. The owner’s detailed records would help an attorney ensure the audit runs smoothly.

Right to Representation and Appeal

Coping with an IRS audit while working every day and overseeing your employees is no easy task. You have a right to legal representation and to have someone manage your audit.

It may take up to 30 days for the IRS to review your documents and make a decision in your case. There are three possible outcomes:

• They decide there was no error and close the case
• They suggest a change that you agree with, paying any additional taxes or penalties
• You disagree with their conclusion and appeal your case

You can only appeal if you disagree with the audit’s result. If you are unable to pay your taxes, there are other avenues to pursue. Discuss these with your attorney if you agree with the conclusion but cannot pay any increased taxes and penalties.

If you want to appeal, there is a limited time to file your case. You must mail your request to the proper office, which is not the IRS collections office. The IRS will continue to process your case while your appeal is pending, and may refer you to mediation to resolve the issue. Your tax attorney can give you more advice on whether you qualify for an appeal after your audit, and whether doing so is the best route to take.

Get Legal Advice From a Tax Attorney

Small business owners can find tax laws complex, especially when it comes to deductions. Understanding deductible and non-deductible business expenses is the job of tax professionals. Speaking with a tax attorney can make an audit much easier to handle. Don’t take on the IRS yourself.