In 2018 the Internal Revenue Service (IRS) processed over 250 million tax returns and other forms. Smaller budgets and a leaner workforce meant the IRS only audited 0.59% of those returns. Your chances of avoiding an IRS business audit are pretty good, however, certain factors can raise a few red flags, increasing the probability of being singled out. Here are few things to look out for.
Deducting Meals, Travel and Entertainment for Business
A large write-off in this area can bring unwanted attention from the IRS, especially if the total amount seems a little too high for the business in question. To qualify for appropriate meal deductions you should keep detailed records documenting the amount spent, location, people who attended, and the business purpose. You must also keep receipts for expenses larger than $75, or for lodging expenses that were incurred while traveling away from home. If your files get brought to the attention of the IRS they’re going to be looking for certain entertainment expenses that shouldn’t be deducted, such as an afternoon on the golf course or tickets to a sporting event. Changes in the 2018 tax law eliminated the deduction for entertainment expenses.
Claiming 100% Business Use of a Vehicle
When you file your business taxes you’ll list the depreciation of your car and the percentage of its business use during the year. If you claim 100% business use of your vehicle, you’re creating a reg flag for an IRS business audit. The IRS knows that it’s not common for a person to truly use their vehicle 100% of the time for business purposes, especially if that’s your only vehicle. Always keep a detailed mileage log, calendar, and noted purpose for every road trip.
A sole proprietorship with a loss can raise a few eyebrows within the IRS. In fact, a sole proprietorship on its own can raise awareness because it’s easy for the owner to mix business and personal expenses, taking deductions that they aren’t entitled to. If you find yourself in a legitimate situation where numbers were in the red, look carefully at whether your deductions are actually allowed under the tax code. The exception to this case are startups – the IRS is not as likely to audit a startup that has lost money in the initial stages of business.
Credit-card processors submit 1099-K forms to the IRS with a record of your credit card transactions for the year. The IRS will run those numbers through a formula that tells them how much your business should have in cash sales based on the total credit card transactions that year.
Charitable Donations Exceed 3% Limit
People love charitable donations – you feel good about contributing to a worthy cause, and you get a tax break. In addition, charitable donations are easily one of the most popular forms of tax deductions. However, there are charitable contribution limits assigned by the IRS. The IRS knows the average donations that taxpayers make in a tax year. If your donations exceed the average limit while filing your taxes, the IRS could flag you. While the legal limit to claim charitable deductions is 60% of your adjusted gross income, it’s best practice to keep your limit at 3% to avoid being red flagged by the IRS.
Being Self Employed
One thing many self employed entrepreneurs like are the many tax breaks they receive, and things turned even more in their favor with the big breaks they received in the new 2018 law, but the IRS is very aware that some people who are self employed may claim excessive deductions and not report all their income. If you’re in a cash-based business you’re also subject to being noticed, think hair stylists, wait staff, and Uber drivers.
You Don’t Disclose Financial Assets Located Abroad
According to the Foreign Account Tax Compliance Act (FATCA), it is mandatory for businesses to report financial assets and bank accounts that are located abroad. If you don’t disclose those foreign assets, the IRS can still trace them through third-party foreign institutions that are required to account certain details of U.S. citizens.
If the value of your foreign assets is over $50,000 (or $100,000 in the case of joint filing for married couples), as a U.S. citizen you must report them in Form 8938 when filing your tax return.
FATCA is different than FBAR (Foreign Bank and Financial Accounts), which is for reporting financial transactions abroad, like overseas banks accounts, that are worth more than $10,000. You don’t have to report FBAR along with your tax return because it is filed as a separate form with the IRS, specifically for businesses with financial accounts abroad. Filing the FBAR can help to avoid IRS scrutiny in the case that you are ever required to show proof of your overseas bank accounts.
You Mix Business & Personal
We all know that tax deductions help increase your tax break, but excessive business tax deductions could be a sign that you’re mixing personal tax deductions with business. As best practice, always use separate bank accounts and credit cards for your business and personal expenses.
Additionally, mixing business and personal expenses to claim a deduction can become tricky if you’re claiming your home office as a deduction. You must indicate the square footage for your business versus your home on the tax form to separate your personal utility expenses from your business expenses.