I often receive phone calls from small business owners concerned they will be the target of an IRS audit. The prospect of an audit is scary. However, the reality is that only a small fraction of small businesses actually get audited. That being said, if you are among the percentage of small businesses facing an audit, there’s nothing to fear from the IRS as long as you’re prepared and have an experienced tax attorney to help you. Here’s some information about what issues on a tax return may trigger the IRS to audit your small business.
Generally, small business audits stem from the Schedule C (Form 1040). This is the form on your tax return where you report income or loss from a small business you operated or a profession you practiced as a sole proprietor. Most businesses — small and otherwise — report their deductions on the Schedule C. Typically, it’s the deductions that trigger the IRS to look at a business for audit purposes. Here are the most common deductions that may start an audit.
High Home Office Deductions — Home offices need to be used exclusively and regularly for business, and it needs to be a legitimate workspace and designated area in your home. This means a spot at the kitchen table where you eat your meals does not count as a home office.
High Meal and Entertainment Deductions — The IRS does allow for tax deductions on meals and entertainment for business development purposes. However, the expenses must be within a reasonable amount and should be either part of client relations or business travel. The coffee or lunch you purchase for yourself while driving as part of daily business does not count as a tax deductible expense and it’s those deductions that send up a red flag audit to the IRS.
Claiming Your Vehicle Exclusively for Business Use — Most small business owners and entrepreneurs use their personal vehicle for work. Very rarely do you use a car that was purchased for your business and is “owned” by the business. And unless it was purchased by the business itself, you cannot deduct 100 percent of your automobile expenses. The general rule should be to track and claim your mileage as the standard mileage rate.
Missing Income and Losses — Even if you did not receive a Form 1099 for money you received, the income should still be reported on your schedule C. Not reporting income from a 1099 can also trigger an audit, especially if the IRS compares the amount you report on your return to any 1099s or W-2s it receives. The IRS also takes note if you continually report losses on your Schedule C. Generally, small businesses need to earn a profit for three out of five years. If you do not turn a profit, your business is considered a hobby. As such, you can only deduct expenses up to the amount you earn from the hobby.
Pandemic Stimulus Payments — Many small business owners received pandemic relief in the form of loans from the Paycheck Protection Program or CARES Act. These pandemic relief measures were intended to be used for payroll, rent, interest, and utilities so businesses could continue operating during the COVID-19 pandemic. Make sure to report stimulus payments and account for expenses so that if the IRS decides to audit your small business, you’ll be able to show how the funds were used.
The idea of an IRS audit is scary, especially if you’re a small business. If you find yourself facing a Schedule C audit, do not try to navigate it yourself. Work with an experience tax attorney who can help keep your small business safe and operating into the future.
Allison Soares is a partner and tax attorney at Vanst Law. Before starting her own practice, Soares was a partner at a tax law firm where she honed her skills handling a wide variety of tax and employment-related cases. In addition to her legal work, she has worked in accounting and utilizes that knowledge to her advantage while handling cases involving EDD audits.
