Wells Fargo Small Business Roundup

During the past few years, the IRS has stepped up its scrutiny of small businesses in a number of areas: ensuring that they’re paying payroll taxes and workers’ comp and the way they classify contractors. In addition, the organization has stepped up its audit operations on those taxpayers who are part of S Corporations and LLCs. In fact, of the $6.6 billion currently spent on tax enforcement, 41% goes toward dealing with small business.

“The IRS has specific situations that alert it to scrutinize certain taxpayers,” notes tax attorney Darrin T. Mish, P.A., author of the IRS Problem Solver Blog. “Its criteria for audit selection are not available to the general public, but from experience and testimony, reliable information regarding these specific situations has been identified.” Mish outlines the following common situations considered “audit red flags” by the IRS:

Excessive income from self-employment.
Any unreported income—The IRS matches all taxable income reported on a taxpayer’s return with the information it receives from employers and from 1099 forms issued by banks and brokerage firms.
Improperly classifying independent contractors—Check out Independent Contractor or Employee? at the IRS website to learn more.
Owning interest in a small business or partnership—If a business is audited and shows an increase in taxable income, each individual owner might be audited.
Deducting business losses—For example, you can’t deduct net losses from hobbies.
In-home office deductions—Any area in your home designated as office space must be used exclusively for business.
Bartering—If you do any bartering, you must report the fair market value of the items or services for which you’ve traded.
Taking abnormally large itemized deductions—If your itemized deductions exceed 35% of your adjusted gross income, that’s a red flag. Also, if, for example, you were to report $50,000 in income and show $20,000 in mortgage interest, the IRS might scrutinize your return more closely.
Claiming too many deductions—Your return might be flagged if you claim large deductions for business travel and entertainment, take a home office deduction or show a large overall loss. Retain all receipts for business meal and entertainment expenditures of $75 or more. For expenses less than $75, keeping a detailed diary is sufficient. In addition, the IRS employs a program called discriminate index function (DIF), which compares taxpayer deductions to others in the same income bracket. If the IRS’s DIF data finds, for example, that the average taxpayer in your income tax bracket claims $1,000 in charitable donations, and you claim $10,000, it’s a likely red flag.
Income exceeding $100,000—It’s cost effective for the IRS to audit these returns.
Past audits with deficiencies—If any taxpayer has a history of inaccurate returns, it’s a red flag.
Claiming losses from “tax shelters”—Any investment that generates losses can be a red flag.
A tax return that includes alimony and claims someone who does not live with you—Rules regarding alimony claims are complex and most taxpayers fail to qualify. The IRS allows only the parent living with the child to claim that child as a dependent. Otherwise, you need a tax waiver signed by the custodial parent to take the write-off. The IRS matches tax deductions for alimony payments by one former spouse with the taxable income reported by the other.