How to Avoid an S Corp Audit: 17 S Corp Audit Triggers
For many small and medium-sized businesses, operating as an S corporation (S corp) offers significant tax advantages. However, despite the relatively low audit rate of 0.1% for S corps, certain practices can increase the likelihood of drawing IRS scrutiny. Understanding these common audit triggers can help you manage your business more effectively and avoid potential pitfalls. Here are the key S corp audit triggers:
17 S Corp Audit Triggers
- Low or No Compensation for Shareholders – Paying shareholders very low salaries while distributing significant profits can raise suspicions. The IRS requires that shareholder-employees receive reasonable compensation for the work they perform. Low or no compensation can be seen as an attempt to avoid payroll taxes. Plus, this is very easy to audit since officer’s compensation is separately stated on Line 7 of the 1120-S. Most IRS notices and audits are system generated so having a very low ratio of compensation of officers to business profit could trigger an IRS notice or audit.
- Discrepancies Between Different Tax Forms – Inconsistencies between the information reported on various tax forms (e.g., 1099s, W-2s, etc.) can trigger an audit. Ensure all forms are accurate and the information matches across all filings. For example, if compensation of officers (Line 7 on the 1120-S) shows $250,000 of wages paid, however the W-2s issued by the company sum to $50,000, this could cause an issue.
- Rounded Numbers – Using rounded numbers consistently on tax returns can trigger an audit. The IRS expects to see precise figures, so always report exact amounts. I don’t recommend showing your meals as exactly $2,000 and office supplies as exactly $4,000. The odds of this happening are very slim, so avoid reporting this. Â
- Mathematical Errors –Â Simple mathematical mistakes or omissions on tax returns, such as incorrect Social Security numbers is an IRS red flag. For this reason, we recommend e-filing over paper-filing.
- Prior Year Inconsistencies – It’s important that the beginning of tax year numbers on the balance sheet (Schedule L) and AAA (Schedule M-2) match the end of year numbers on the prior year tax return.
- Prior Offenses – Businesses that have previously been audited and the IRS has suggested changes opens up the door to be audited again in the future.
- Large Swings in Income and Expenses –Â The IRS looks for consistency in income and expenses from year to year. Large fluctuations can raise red flags, suggesting that income may be underreported in profitable years or that expenses are being exaggerated to offset income.
- Significant Business Meals and Travel Expenses –Â The IRS scrutinizes significant business meals and travel expenses because these areas are prone to abuse. Excessive or unsubstantiated claims can signal that personal expenses are being improperly deducted as business expenses.
- Industries with Significant Cash Transactions –Â Businesses that deal primarily in cash are often scrutinized by the IRS due to the higher potential for underreporting income. Examples include restaurants, transportation, bars, beauty salons, and automotive repair shops.
- Significant Contractor Deductions with No 1099s Filed –Â The IRS requires that businesses report payments made to independent contractors by filing Form 1099-NEC. Failing to do so, especially when claiming significant contractor deductions, can trigger an audit.
- Double Dipping on Vehicle Deductions – S corps are able to deduct vehicle expenses via the actual expense method (including depreciation) or a standard mileage reimbursement, but not both. Double dipping on vehicle and mileage expenses is one of the S corp audit triggers.
- Non-Filers –Â Failing to file required tax returns is a major red flag. The IRS actively pursues non-filers as this could indicate unreported income or other compliance issues
- Using a Non-Reputable Tax Preparer –Â Some unscrupulous tax preparers engage in fraudulent practices to artificially inflate refunds or reduce tax liabilities. This includes claiming false deductions, credits, or exemptions. The IRS has systems in place to detect such fraudulent activities and using a preparer involved in these practices can result in your return being flagged for an audit.
- Disproportionate Deductions to Income –Â One of the most common red flags for an IRS audit is claiming deductions that are disproportionately large compared to your income. The IRS may suspect that you’re inflating deductions or underreporting income to reduce your tax liability.
- Year Over Year Business Losses –Â Consistently reporting business losses year after year can raise red flags for the IRS. The agency may question the legitimacy of your business and suspect that it is a hobby rather than a profit-driven enterprise. The IRS generally expects businesses to be profitable in at least three of the past five years.
- Misclassification of Employees and Independent Contractors –Â The IRS is vigilant about the correct classification of workers because misclassification can lead to underpayment of IRS payroll taxes. Employees and independent contractors have different tax implications, and misclassifying employees as independent contractors to avoid payroll taxes is a serious issue.
- Related-Party Transactions – Transactions between related parties, such as loans to shareholders, can be scrutinized for proper documentation and adherence to tax rules.
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About the Author
Brett Rosenstein
Founder of S Corp Advantages
Certified Public Accountant
Brett is the founder and president of S Corp Advantages where he specializes in S corporations. He helps business owners understand if an S corporation election is right for their business. He also keeps current S corps in compliance with IRS regulations.
Brett received a Bachelor of Science in Business Administration from The Ohio State University. He is also a Certified Public Accountant.
When Brett is not working, he is running, biking, spending time with his wife and daughter, or trying new pizza places around Chicago.
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