IRS Audits: Red Flags and Risks
Internal Revenue Service (IRS) audits can be stressful for businesses of all sizes. While audits are not always the result of wrongdoing, certain reporting patterns, commonly known as audit red flags, can significantly increase the likelihood that a tax return is selected for review.
Understanding these red flags enables business owners to reduce risk, maintain compliance and respond effectively if an audit occurs.
Who Gets Audited?
IRS audits occur for a variety of reasons. Some returns are selected randomly through statistical sampling designed to measure overall tax compliance. Others are chosen because they involve related parties, such as businesses connected to taxpayers already under audit. Amended returns may also attract attention, particularly when they result in significant changes to income or deductions.
Most commonly, audits are triggered by red flags — items on a return that appear inconsistent, unusually large or outside normal industry patterns. While the presence of a red flag does not guarantee an audit, it does increase the likelihood of further scrutiny. Accurate, complete and consistent reporting is therefore essential to minimizing audit risk.
Common IRS Audit Red Flags
1. Unreported Income. Unreported income is one of the most frequent causes of IRS audits. The IRS compares income reported on business tax returns, including Forms 1120, 1120S, 1065 and Schedule C, with third-party information reported on forms such as 1099-NEC, 1099-MISC and 1099-INT. Discrepancies between these sources often trigger review. The IRS may also analyze bank deposits to identify unexplained income. Cash-heavy businesses are subject to increased scrutiny due to the higher risk of underreporting.
2. Disproportionate Deductions or Recurring Losses. Deductions that appear disproportionate to revenue frequently raise concerns. Expenses for meals, travel or supplies may be questioned when they seem excessive compared to gross receipts. Additionally, businesses reporting losses year after year may be examined to determine whether the activity is conducted for profit. Under Internal Revenue Code §183, commonly referred to as the hobby loss rules, deductions may be limited if the activity lacks a genuine profit motive.
3. Personal Expenses Claimed as Business Deductions. Claiming personal expenses as business deductions is a common audit issue. Luxury vehicle deductions are often scrutinized, especially when taxpayers claim full depreciation without adequate documentation of business use. Business meals, travel and similar expenses must be ordinary, necessary and properly substantiated. Compensation paid to family members may also draw attention if wages appear excessive or if there is insufficient documentation of job duties and hours worked.
4. Worker Misclassification. Misclassifying employees as independent contractors to avoid payroll taxes and benefits presents significant audit risk. The IRS closely examines worker classification and compliance with Form 1099-NEC filing requirements. Errors in this area can result in substantial penalties and may lead to expanded audits.
5. Incomplete or Inconsistent Filings. Incomplete or inconsistent filings frequently trigger scrutiny. Business returns should include all required schedules and supporting forms, most commonly Schedule M-1 (reconciling book and tax income), Schedule M-2 (tracking equity or capital accounts) and Schedule L (balance sheet). Missing Forms 1125-A (cost of goods sold) or 1125-E (officer compensation) may also prompt further inquiry.
Conclusion
While IRS audits are not always avoidable, many can be prevented through proactive compliance and careful planning. By understanding common audit red flags, maintaining thorough and well-organized documentation and filing complete and consistent returns, businesses can significantly reduce their audit risk. Regular review of tax filings, proper substantiation of income and deductions, along with timely submission of required forms all play a critical role in minimizing exposure. For business owners, working closely with qualified tax professionals can help identify potential issues before a return is filed and ensure compliance with evolving IRS rules.
Contributing author: Abby K. Sweers, CPA, is a tax senior manager at the firm. Abby brings extensive experience in preparing and reviewing individual and corporate tax engagements, including tax planning and compliance. She specializes in the manufacturing and construction industries, multi-state entities and high-net-worth individuals. For more information on this topic, contact Abby at asweers@dmcpas.com.