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IRS Audit Triggers - Be Ready to Defend Your Business

Matt Edrington
November 9, 2022

The IRS is always scanning small business tax returns that look unusual or out of the ordinary. Here are five areas of your business to be ready to defend should the IRS start asking you questions.

Business vs hobby. Be ready to provide proof your business is truly a business and not a hobby. Those who fail in the eyes of the IRS can have their expense deductions severely limited, while still required to report the income. Make sure you can answer and provide documentation for these four questions:
1. What is your profit motive?
2. Are you an active participant in the business?
3. Are you conducting the activity in a business-like manner?
4. What expertise do you have in the service or products your business provides?
Reasonable shareholder salary. S corporations are in the unique situation where some compensation is excluded from payroll taxes. Many businesses take this too far. The IRS is looking closely at businesses who avoid paying a reasonable salary in order to lower their Social Security and Medicare tax bills. When determining salaries for shareholders, consider their experience, duties, responsibilities and time devoted to the business. Once you have a picture of their ongoing contributions to the business, research comparable positions and salary ranges to pinpoint a fair salary. Save your findings and calculations as backup to provide in the event of an audit.
Contractors vs employees. Make sure consultants and other suppliers are not employees in disguise. The IRS looks at how much control you have over the work being done – the more control you exert, the higher likelihood you may have an employee versus a contractor. Penalties can be very steep if the IRS decides your consultant is really your employee. If in doubt, ask for a review.
Meal and travel expenses. Documentation for business meal expenses, as well as travel expenses, should include receipts, who attended the meal, and the business purpose of the meal. Bringing food in for business lunches rather than going out is a safe way to show business intent.
W-2 and 1099 forms. Don’t forget to file all required 1099s and W-2s. Most of them are due on or before Jan. 31. The IRS is penalty crazy in this area with up to $270 per missing or incorrect form.

Knowing what the IRS is looking for helps you prepare should it turn its focus to your business.

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