Top 5 Reasons the IRS May Audit a Business
Everyone hopes to avoid an IRS audit, but they do happen. The IRS website offers very clear information about what types of activities are likely to draw attention. Broadly, if the service identifies income you’re not reporting, lacks reports you’re required to make, or questions the nature of your employee classifications or certain types of deductions, you may receive more “personal attention” from the IRS than you’d like.
The Top 5 Reasons
Of course, there are many more reasons a business or individual could be audited, but some specific factors that are likely to draw IRS attention include the following:
1. Information doesn't match what the IRS has
A taxpayer may be selected through computerized underreporting because the information reported on the taxpayer's return does not match the information obtained by the IRS. Business tax returns now ask whether a business has filed all required Forms 1099-MISC. A taxpayer is required to file a Form 1099-MISC for each person to whom the taxpayer pays: (a) at least $10 in royalties or broker payments in lieu of dividends or tax-exempt interest; or (b) at least $600 in various other payments, including for rents and services performed by a person who is not an employee.
2. Failure to make timely payroll tax payments
If an employer fails to file payroll tax returns or make timely payroll tax payments, that can draw IRS interest. Companies that demonstrate inconsistent behavior or unwillingness to comply with their payroll tax requirements may have their businesses shut down by the IRS.
3. Employees are misclassified
An employer may be selected for audit if the IRS has reason to believe the employer may have misclassified W-2 employees as independent contractors. The IRS analyzes three key factors:
- Behavioral control: If the employer provides extensive instruction on how the work is to be performed, controls how and where work takes place, and provides equipment and training, the IRS is likely to find that the worker is an employee and not an independent contractor.
- Financial control: If a worker is expected to purchase items required to conduct work, it is likely he or she will be considered an independent contractor. However, if the employer reimburses for expenses, utilities, and supplies used on the job, then it’s likely the person would be classified as an employee.
- Relationship of the parties: The IRS may review whether a written contract exists and whether employee benefits are provided. If a taxpayer provides a worker with insurance, a pension, and paid time off, the IRS is likely to find that the worker is an employee even if there is a contract that defines the relationship as an independent contractor.
4. Disproportionate deductions claimed
If the taxpayer’s deductions claimed are disproportionate to income claimed from a business, the IRS will want to know where the money comes from to pay those expenses. To be eligible for a deduction, purchases must be 1) ordinary and 2) necessary. A large write-off will set off alarm bells, especially if the amount seems too high for the business or profession.
5. Claiming home office space
Claiming a portion of home as office space: The IRS will want to know what the percentage of office space is in relation to the taxpayer's overall home; how the taxpayer calculated any percentage allocated to his or her utilities; and if the office is used for anything other than business purposes. This is an area prone to fraud, and as the IRS defines this deduction narrowly, it often leads to more scrutiny.
The IRS plays the role of tax referee. If you’re playing by the rules (counting all your strokes, properly inflating the footballs, etc.), you’re not likely to draw attention to yourself. But trying to take advantage of the “game” by cheating is a good way to attract attention and drag your business through a painful resolution process. Stay clear of the “ref” by knowing – and following – the rules.
For more information about this topic, contact your AGH tax professional or AGH tax supervisor Raymond Hall using his information below.
Raymond joined the firm in 2014, bringing with him 14 years of public accounting experience in Federal and state taxation and financial accounting. He handles federal and multi-state tax compliance for partnerships and corporations, with a focus on tax research and special projects including tax accounting method changes.
Raymond works frequently with clients in the manufacturing, wholesale/retail distribution, real estate development and management, construction and banking industries.
He earned a bachelor’s degree in accounting from Bethel College and a master’s of professional accountancy from Wichita State University. He is a certified public accountant and a member of both the American Institute of CPAs and the Kansas Society of CPAs.
NOTE: Any advice contained in this material is not intended or written to be tax advice, and cannot be relied upon as such, nor can it be used for the purpose of avoiding tax penalties that may be imposed by the IRS or states, or promoting, marketing or recommending to another party any transaction or matter addressed herein.