It’s easy to feel concerned about the Internal Revenue Service (IRS) one day knocking on your door, wanting to conduct an audit of your business. But small business tax audit triggers become a thing of the past when you work with a tax professional to ensure you aren’t making compliance errors.
A certified tax professional will guide you every step of the way, making sure you’re paying the least amount of tax possible and staying on side when it comes to compliance. However, if you’re still concerned, here are a few small business tax audit triggers to watch out for.
Meals, Travel, and Entertainment Expenses
The rules regarding what you can deduct as a business expense when it comes to meals, travel, and entertainment, are very specific. As such, the IRS keeps a close eye on these expenses and will request documentation if they seem out of line for the type of business you run.
In a recent update on business meals and entertainment expenses, final regulations state that in order to qualify as an eligible business expense, food or beverages must be provided to “a person with whom the taxpayer could reasonably be expected” to do business with. This could include:
- Partners, or
- Professional business advisers.
Entertainment expenses are treated separately from food and beverages and are handled differently depending on whether or not they are part of compensation to an employee and are included in the employee’s gross income.
If you use a personal vehicle for business purposes, you can claim the business portion of those vehicle expenses on your business tax return. There are two ways to do this: claiming the actual expenses prorated for the business portion, or claiming mileage. Claiming both will likely result in an audit.
To calculate the business portion of your vehicle expenses, keep a notebook in your vehicle at all times and make note of the date, the starting odometer reading, how far you drove, and the purpose of the trip.
At the end of the year you can add up all the miles travelled for business purposes, divide that number by the total miles driven, and multiply by 100. This will tell you what percentage you used the vehicle for business. Once you have this percentage, you can use that portion of your fuel, oil, vehicle insurance, parking, and vehicle repairs as a deduction against your business income.
A second way to claim vehicle expenses on your business tax return is the flat rate method. The flat rate is set by the IRS. For the 2020 tax year is 57.5 cents per mile, and for the 2021 tax year it is down to 56 cents per mile. There are special restrictions as to when you can use the per mile rate for calculating your vehicle expenses. We’re happy to help determine if you qualify to use this method.
Home Office Expenses – Small Business Tax Audit Triggers
Are you noticing a pattern?
There are a lot of great deductions available to business owners, but they all come with special restrictions, which is why claiming them incorrectly can turn them into a small business tax audit trigger. Home office expenses are another example.
The key thing to keep in mind with the home office expense deduction is that the work space must be used exclusively for conducting business on a regular basis. Like with vehicle expenses, there are two ways to calculate this deduction: by calculating the business use of the space or by using a simplified method.
This IRS Tax Tip provides more details about claiming the home office deduction.
Once your business is to the point that you need day-to-day help, it may be tempting to hire a contractor and forego all the paperwork and required payroll filings that come with hiring employees. This would be a huge mistake.
The IRS draws a very clear distinction between employees and contractors, and as such, they are handled differently when it comes to deducting expenses in your business. When you hire independent contractors, you are responsible for paying their invoices. With employees, you need to pay workers compensation, payroll taxes, and benefits in addition to their wages.
The expense that comes with hiring employees can be substantially more than if you were to hire a contractor, but the decision regarding whether a worker is a contractor or an employee is based on tax laws. The degree of control the worker has is the main thing the IRS will look at to determine if they are truly a contractor. If the worker can choose their own hours and rate of pay and they use their own tools and equipment, they’re a contractor. If not, then they’re an employee.
If you deduct a lot of contractor payments in your business, be prepared to back them up with appropriate evidence such as a work agreement detailing who is responsible for providing tools, setting work hours, and sending invoices, etc.
Claiming Losses Year After Year
You have a business loss when your costs exceed your income for the year. In some cases, you may be able to get a refund as a result of claiming business losses. Special rules apply regarding losses from 2020, so consider some business year end tax planning to determine if this applies to you.
Most entrepreneurs are in business to earn a living. If the IRS sees that you are continually claiming business losses, they will wonder how you’re supporting yourself and likely want to audit you. It’s normal for a business to have losses in its first five years, but even during that time, you’ll want to make sure your income and expenses are well documented.
If this all feels a bit overwhelming, we’re here to help. At Levy Lauter, LLP, our tax compliance services ensure you only claim deductions and credits you’re eligible for. And if you’re ever submitted to a small business tax audit, we’ve got you covered there too. Schedule a call today to learn more about how we can help.