The IRS conducts audits on a regular basis.
Even for small businesses that remain compliant, risks always exist—no matter how honest you are with your taxes. Ultimately, it’s a combination of software and random selections that can put small business owners in a bind. Every business needs to be prepared.
What the experts say about avoiding audits
“While often unavoidable, there are a number of red flags that can trigger an audit, explains Nate Masterson, financial manager at Maple Holistics. “Therefore, it’s in your best interest to take the necessary steps to appear above board. This doesn’t mean that you should operate off the books, it just means knowing which suspicious accounting methods may warrant an audit.”
“Suspicious activity can be as innocuous as reporting yearly losses, paying high employee salaries to shareholders, or claiming a home-office deduction. While home office deductions aren’t inherently suspicious, many companies use the deduction to circumvent taxes.”
The best way to avoid a fallout from an audit is to always remain prepared for one. That means keeping detailed accounting records, using software to stay organized. Business owners who work with professional tax preparers also experience a lower audit risk, according to some experts. The QuickBooks team interviewed a handful of experts to share their experience, tips, feedback, and best practices. Here are recommendations from 3 payroll, accounting, and finance experts:
Bonnie Lee, president at Taxpertise and enrolled agent to represent taxpayers from all 50 states
“Hire a payroll company to handle all aspects of payroll from preparation to reporting to the depositing of payroll tax liabilities. Businesses using an outside professional are less likely to be audited. Make sure that all payroll tax returns are timely filed and all payroll tax deposits made in a timely manner. Know the difference between contract workers (1099) and employees. And make sure you are not paying an employee on a 1099 basis. Don’t pay any worker with both a 1099 and a W2. This raises a red flag with the IRS.
“When deciding to hire an employee, consider not only the salary or wage of the employee but also budget in all other costs: employer share of payroll taxes, workers comp insurance, errors & omissions, or other required insurances or bonding, fringe benefits, and any other out-of-pocket expenses.
“Withheld taxes from employee pay is a trust fund held by the employer. If these taxes are not deposited timely or not deposited at all, the IRS and state view this as theft and harshly punish via a 100% trust fund penalty. There is no statute of limitations on trust fund payroll taxes and the liability cannot be discharged in bankruptcy. If a business owner is having cash flow difficulties, it’s more important to pay the withheld portion (versus the employer share) of employee pay than it is to pay the rent.”
You can learn more about Lee’s work, and her experiences resolving tax problems, at Taxpertise.
Vern Gohanna, owner and president of TaxCorp—Who also spent a decade conducting investigations for the IRS
“Don’t disguise overtime pay as other compensation. I have seen many employers digitize overtime hours (time and a half) as per diem or reimbursement for an expense incurred on behalf of the business (fuel, supplies, etc). The employers save the additional tax on the 150% wage base for the hours worked (social security and Medicare).
“Many businesses incorrectly believe if they don¹t file a return the tax will not become due until it is. This is incorrect. The tax is due beginning with the date the tax return is due (30 days after the end of the previous quarter for four 941) and Jan 31 of year for four 940. Failure to file these returns will result in a potential 25% penalty on the amount owed for each return plus interest.
“Make timely W2 and W3 filings to the Social Security Administration. The penalty can range anywhere from $50 to $530 per form W-2, depending on the lateness of the filing. If a company has 10 employees the penalty could range from $500-$5,300.”
If you are not careful about the timing of your filings, the penalties and costs may add up. You can learn more about Gohanna’s work on the TaxCorp website.
Jon Miller, CPA and managing member at Private Tax Solutions
“Make sure all payments from the business to individuals are included in the company’s payroll. Many small businesses make the mistake at the end of the year of writing out a bonus check to an employee and forgetting to run it through their payroll software. Mistakes like this can result in hefty IRS penalties.”
“Don’t misclassify employees as contractors. Many business owners mistakenly think they can avoid payroll taxes by characterizing an employee as a contractor and issuing a 1099 instead of a W-2. The IRS looks for such situations and will assess not only the payroll taxes but also huge penalties for misclassifying employees. Misclassifying employees can also create problems with worker’s compensation if an injury occurs on the job.”
“Ensure that all compensation paid to the business owners is reasonable. Many business owners who have organized their company as an S-corporation don’t pay themselves a reasonable wage. The IRS actively searches for under compensated owners in their examinations, and will assess huge penalties if the business can’t prove the owner compensation is reasonable.”
You can learn more about Jon Miller’s perspectives and work at Private Tax Solutions.
Every business is unique. As a result, every business has different levels of audit risk. The best way to understand yours is to work with a tax preparer and payroll consultant or to use QuickBooks Payroll to do all the work for you. Should you undergo an audit, having organized books—and a tax preparer who can advocate on your behalf—will make the process easier.