Eight Ways Small Businesses Invite IRS Audit

by Lynnea Bylund on February 24, 2011 · 4 comments

As a small business owner, if you aren’t concerned about a tax audit, you should be.  An IRS audit can be a troubling experience  even if you’re completely prepared.  Make no mistake, your IRS auditor won’t be especially charming.

IRS small business auditDue largely to a humongous budget deficit, the government is trying to close a $300 billion gap between what people pay in taxes and what the IRS believes we should have paid. “You aren’t paranoid if someone is really out get you, as the saying goes, and the IRS really is out to get you,” reports Kate Lister at AMEX Open Forum

According to CFO Zone, the audits will focus on four key areas:

Worker Classification: Whether workers are classified as employees or independent contractors.

Executive compensation: Salary and non-salary compensation, such as loans, deferred compensation and stock.

Fringe benefits: Perks for executives and employees.

Payroll taxes: The IRS will be looking closely at Forms 941 and Form 1099/W-2 for issues including withholding and next-day deposit requirements.

Twice as many tax returns were audited in 2009 as 2000. Enforcement revenue over the same period was up 50 percent.

More from Kate Lister

It’s important to note that in this land of equality, not all individuals or companies are treated equally when it comes their chances of an audit. About one in a hundred businesses with less than $10 million in assets is audited. That number jumps to 10 in a hundred for those with $10-$50 million in assets, and one in four for businesses with assets greater than $250 million.

Certain industries are scrutinized more heavily too. You can probably guess some of them—cash businesses are always high on the IRS hit list. But would you suspect Dr. Doggie, the vet, is a target too? It turns out the IRS has a special auditor guidebooks for veterinarians, and for ministers, laundromats, car dealers and many others too. Their Retailer Guide offers specific strategies for interrogating e-commerce businesses, gas stations, direct sellers, mobile food vendors, pizza shops and the like.

You can read all about how auditors are instructed to look for tax cheats in these publicly available guides. They’re not easy reading like a John Grisham novel, but they will make the hair on your neck stand on end.

Here are some “red flags” that commonly trigger an audit:

1. Math Errors

While an error in basic math might not instigate a full blown line-item audit, it’s the most common reason Americans receive those heart-attack inducing letters from their friendly local IRS office. Use a calculator and check your numbers twice.

2. Unusually High Itemized Deductions

The IRS uses a very secret formula to calculate what your deductions should be. If computer scan of your returns shows that your deductions for charity, travel and entertainment, and healthcare are out of line with your income, you’ll be on their radar.

3. Self-Employed/Schedule C Filers

Small businesses are suspected of being especially creative with their expenses. Be careful if you take a home office deduction, have lost money for several years in a row, and prepare your returns yourself rather than use an accountant.

4. Lots of 1099s

In February of 2010, in hopes of adding billions to depleted U.S. Treasury coffers, the IRS began a three-year initiative to crack down on what they believe to be a common practice of misclassifying employees as contractors.

Six thousand businesses have already been targeted for audit, and the government hopes to hire 100 new Department of Labor employees specifically to police these abuses. And yes, the do share their successes with the IRS and State authorities.

5. Unreported Income

Be especially careful to report all your income. If you’ve received a 1099, so has the IRS and their computers will notice if they don’t match up.

The same is true for other sources of income. If your former spouse reports alimony paid and you don’t report receiving it, you’ve just painted a big bull’s-eye on your tax return.

6. Previously Audited

If you’ve been audited in the past don’t think you’re off the hook—especially if you owed taxes or fines. The IRS knows people have the mistaken impression that the auditor won’t come knocking twice. But, of course, just the opposite is true.

7. Shareholder

If you are an investor in a partnership or corporation that came under the gimlet eye of the Feds, you may be next in line.

8. Pissed Someone Off

Disgruntled former employees are a regular source of IRS tips. But payback isn’t the only reason people go the IRS—the agency is authorized by law to pay rewards to informants. In cases that involve huge amounts of money, the informant’s cut can be as high as 30 percent of what they collect.


1 Ben Lang March 2, 2011 at 2:22 am

I see I have to be more careful. thanks for the info on the IRS 🙂

2 Joel Allgaeuer March 5, 2011 at 1:06 pm

Wow, great post – how to avoid an audit is important.

3 mario gordon March 31, 2011 at 12:41 pm

Very good list to be alert for.

4 Ralaclifede March 31, 2011 at 8:14 am

I think there are another 12+ ways in addition to the eight… but who’s counting? Be careful!

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