In December 2017, the passage of the Tax Cuts and Jobs Act (TCJA) gave S Corp and other pass-through business owners an incredible tax benefit—a non-qualified 20 percent deduction from income. For many, this provided the boost needed to hire new employees, expand into a bigger space, or take on more orders.
But while this provision of the TCJA means that many business owners will be able to keep more profits in their pockets, other tax law changes can make these business owners especially vulnerable to an IRS audit. If you're self-employed, you already have a higher-than-average risk of being audited; adding one or more "red flags" to your tax return could boost these odds even more.
Now, let’s explore some of the different factors the IRS looks for when it selects taxpayers to be audited, as well as some of the steps that S Corp owners can take to avoid a stressful, time-consuming, and potentially expensive audit.
Some Audit "Red Flags"
Each year, around 0.5 percent (or about 1 in 200) income tax returns are audited. While not all audits are bad—of the million tax returns the IRS audited in 2017, 30,000 of these returns resulted in a refund to the borrower—many can be avoided as long as you shy away from some of the most common red flags.
When it comes to running a business, big losses can mean big tax deductions. Combining these losses with the new 20 percent S Corp deduction can result in significant tax savings to business owners who have had a bad year—which can invite extra scrutiny from the IRS.
Certainly, not all large business losses are preventable, and it's just smart tax planning to use these losses to offset your tax liability where you can. But if your Schedule C shows a large loss for more than three of the last five years, your business may be classified as a "hobby" by the IRS, significantly restricting your ability to deduct certain business expenses. And even if you just have a year or two of large losses, these deductions may be enough to trigger a tax audit.
If you notice a major downturn that's likely to affect your yearly revenue, it can be worthwhile to visit a CPA for some advice on the best way to manage these losses.
Businesses that regularly deal in large amounts of cash can also garner some extra attention from the IRS. Every time someone deposits or withdraws more than $10,000 at once from a bank account, the bank is required to file a Suspicious Activity Report (SAR). These SARs themselves don't present any problem (so long as these withdrawals and deposits are accurately reflected on a tax return), but the more SARs a business generates each year, the better the odds that the business will be audited.
And if you're hoping to avoid a SAR by never depositing more than $9,999, think again—bank employees (and IRS auditors) are trained to look for transactions that seem to be an attempt to bypass the SAR.
Home Office Deductions
The TCJA eliminated the home office deduction for W-2 employees beginning in 2018. However, independent contractors and others who are self-employed can still take advantage of this deduction, which is designed to help these workers offset the cost of maintaining separate office spaces in their homes. If you're planning to take the home office deduction in the foreseeable future, be sure you have plenty of documentation. This deduction can often be a red flag to the IRS due to so many taxpayers overestimating its value.
Avoiding an Audit
Some audits are truly random—which means that there's very little, if anything you can do to avoid them. But with recent reductions in IRS staffing levels and the many tax law changes enacted by the TCJA, the easiest way to reduce your odds of any audit is simply to avoid raising too many red flags in your tax return.
A CPA can help you with this process by carefully reviewing your business's financials and advising you against any potentially risky maneuvers. And if you are audited, having your return prepared by an experienced accountant like Scott Boyar, CPA can ensure you have all the documentation you need to back up any credits or deductions. If you're ready to optimize your tax efficiency, contact our office to learn more about the services we offer.