There are all kinds or rumors out there about IRS and state income tax audits – who gets audited, and why? No one wants this kind of attention: there may be much additional taxes to pay, and lots of intrusive, time-consuming questions. And according to the IRS, an audit may involve “the questioning of witnesses to determine the individual’s or entity’s correct tax liability” – such as your employees, customers and vendors.

And tax authorities will then happily add penalties and interest to amounts owed going back many years.

And in case you’ve been the subject or a recent audit and think that your business will be left alone for a few years – that’s not true either; a new audit may be called at any time if the circumstances warranted.

There is no upside to any of this.

The past cannot be changed unless you want to file amended tax returns. However maybe now is a good time to learn some areas that may well attract unwanted letters and visits from our friendly tax authorities.

Here are seven “red flags” that could prompt Uncle Sam to audit you or your small business (in no particular order):

1. Home Office Deduction.

The IRS has been wary of the “home office deduction” for many years. In general, you may deduct a portion of your rent/payments and utilities but too many small-business owners claim way too much, sometimes 100% on the specious reasoning that everything is really business related. That won’t work. If 15% of your home (based upon square footage) is used for an office that is exclusively used for business – then deduct only 15% of the associated expense. And be prepared for questions if entertainment equipment, swimming pools or other general improvements are somehow included in your numbers.

2.Watch Out For Tax Whistleblowers

The IRS says that “The IRS Whistleblower Office pays money to people who blow the whistle on persons who fail to pay the tax that they owe. If the IRS uses information provided by the whistleblower, it can award up to 30 percent of the additional tax, penalty and other amounts it collects. This may include unhappy ex-employees, ex-employees, jealous or righteous friends, one of your ex-spouses, and just about anyone who knows of tax abuse and wants to earn a little extra-money. The awards may be paid “to people who provide specific and credible information to the IRS if the information results in the collection of taxes, penalties, interest or other amounts from the noncompliant taxpayer . . . this is not a program for resolving personal problems or disputes about a business relationship. These cases sometimes take years to resolve, which is not a productive use of your time. The bottom-line here is to avoid this nuisance by making sure that you, and those around you such as your accounting staff, know that your objective is to remain in compliance.

3. Round Numbers.

Round numbers suggest that you are using estimates, not carefully calculated numbers. This may cause the IRS to ask for detail, and then perhaps to calculate the correct numbers and refile your returns for several years. As noted below, state tax authorities will also be informed of this and so corrected state returns will also be needed.

4. State and Federal Tax Returns are Different

The IRS and state tax authorities are pretty good at exchanging information these days, so make sure that the returns to both are consistent. For example, if different revenue numbers are seen on your IRS Form 1120 (Corporate Tax Return) and the state filing, you will most likely get a letter asking for an explanation. One tax return you’ve already filed must be wrong, so this will not be pleasant. Some numbers are calculated differently by the IRS and states, so this will be ok (for example, depreciation, which will then also affect total expenses and taxable income). This applies to any entity, including Schedule C of your personal tax return. Most tax software can deal with this issue if both federal and state are prepared together.

5. Income Exceeds $200,000.

The IRS says that it audits less than 1 percent of personal tax returns when reported income is below $200,000. But for those unfortunates who make more than $200k, the rate is around 3%. And if you are unlucky enough to make over $1 million a year, the chance of an audit of some kind exceeds 12 percent. Note, however, that those with higher incomes often have much more complex financial and tax situations, so in a way this can be expected.

6. Form 1040 (Schedule C), Profit or Loss from Business (Sole Proprietorship).

There are many opportunities to take unallowable expense deductions on Schedule C (part of your Form 1040, U. S. Individual Income Tax Return) and the IRS knows this. Common areas of abuse include deducting 100% of your automobile expenses (when maybe only 40% is for business use), Education Expenses (your son’s college tuition), Rent, and misclassification of medical and dental expenses. And of course Travel and Entertainment Expenses – I once worked with a plumber who claimed that he wined and dined just about everyone in town and the IRS noticed that his T&E expenses as a percentage of revenue was far outside of the norm for his profession. In this situation, you cannot simply deduct all travel, dining and entertainment expenses off of credit card statements – keep a record, perhaps in a spreadsheet – detailing who you were with and the business purpose. The IRS is wary of Schedule C numbers, especially if you report continual losses and income is over $100,000.

7. Some 1099 or W2 Income Is Not Reported.

The IRS is also getting better at figuring your revenues – even without your help. They just add up all of those W2’s and 1099’s and if you report a lower number, then you will at least get a letter asking for an explanation. And besides this, the IRS knows that much income from cash-based businesses (such as small retailers and restaurants) and self-employed types (such as independent contractors). As more businesses convert to computer-based ales and accounting systems which capture all of the details, it’s much more difficult to avoid reporting these numbers – or to hide anything. Also, be prepared to answer the question “we see some extra deposits in your bank account – what are these and why are they not on your tax returns?”

Contact us if we may help with your business taxes.