Here’s the good news: The odds of a small business being audited by the IRS is low. Some tax experts set it as low as under one percent. But because a small business IRS audit can be a hassle and a source of stress, if possible, it’s a situation best to avoid.
Tips on how to minimize the risk of a small business IRS audit include several things you should be careful not to do, such as:
1) Categorizing an activity as a hobby when it’s a business. The IRS frowns upon you classifying a hobby that results in losses, when in fact it’s really a business.
2) Claiming lavish business expenses. Business expenses eligible for deductions are ones that are considered “ordinary and necessary”. Therefore, be careful in claiming large expenses that are disproportionate to your small business income. For instance, claiming a $8,000 in office furniture may not sit well with the IRS if your overall small business income is $40,000. In this situation, it’s not that the office furniture isn’t considered ordinary and necessary, it’s the disproportionate nature of the expense and income.
3) Paying grossly exaggerated salaries. Paying hefty salaries well beyond comparable salaries in your industry’s employment market, may cause some attention. The Bureau of Labor Statistics Occupation Outlook Handbook provides salary estimates for an authoritative source of reference.
4) Claiming a home office when you shouldn’t. Its long been thought that claiming a home office on your taxes, is a fast and sure-fire way to an IRS audit trigger. Whether rumor or not, it’s best to follow the IRS guidelines to a T when it comes to claiming a home office. In a nutshell, if you plan to claim a home office deduction, be prepared to support that your home office is used exclusively for your small business, and it’s in a dedicated space in your home. For further reading on claiming the home office deduction, refer to IRS Publication 587, Business Use of Your Home.
5) Making mistakes. As part of the IRS’s “document matching” process, sloppy errors can cause your tax return to be flagged, and increases the risk of a small business audit. Fortunately, math errors in tax returns are down, thanks to tax software.
As always, check with a tax accountant on any deductions you’re not certain about.