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Audit Red Flags for Small Corporations
by Mark Minassian, CPA

The IRS has vowed to increase the number of small business audits. And while a lot of their attention will focus on sole proprietors, small corporations will be under the microscope as well.

Here are five areas that the IRS will look at when deciding whether or not to audit a small business corporation:

  1. Compensation of corporate officers. This is the biggest target area for small businesses and the IRS actually has two sets of rules here.

    With a C-Corporation or personal service corporation, they will be looking for compensation that is too high because higher compensation means lower (or no) taxable income. Since a C-Corporation pays tax on its taxable income, the IRS misses out here. Also, if a C-Corp has taxable income and the owners want to receive distributions of these profits (dividends) from the corporation, they will pay tax on those dividends individually, leading to double-taxation. The usual strategy for small corporations is to pay out bonuses at the end of the year to zero-out any profit in the corporation and thus avoid paying tax at the corporate level and avoid receiving dividends. There is nothing wrong with doing this, but the IRS will be on the lookout for excessive salaries and bonuses.

    With S-Corporations, the IRS will be looking for shareholder-employee salaries that are too low. S-Corporation shareholders can take profit distributions from the corporation without incurring double-taxation and without paying payroll taxes. The common practice used to be for shareholder-employees to take low (or no) salaries and high profit distributions to avoid payroll taxes. The IRS has made this a big area of audit emphasis over the past few years.

  2. Accounting method. Businesses can generally use either the cash method or accrual method of accounting when preparing their tax returns. Any business may use the accrual method, but only certain businesses may use the cash method. Many businesses (especially service businesses) want to use the cash method because they will not have to pay tax on their accounts receivable; they only pay taxes on the income actually received during the year. However, if you report your tax return on the cash basis and you are required to use the accrual basis, expect the IRS to come and change your returns to the accrual basis. This can lead to a large and unexpected tax bill, especially if you have a large amount of receivables.

    TIP: If you report your tax returns on the cash basis make sure you (or your accountant) review the returns annually to make sure your company is still eligible to use the cash basis for tax purposes. As a business grows, it is very common to be eligible for the cash basis in one year and not in the next. And once you are forced to use the accrual basis, you must stick with that even if you fall below the threshold.

  3. Using independent contractors. There are two issues that the IRS will be looking for when a business uses independent contractors. The first and biggest issue is whether the contractors should actually be employees. It is very, very common for businesses to treat workers as independent contractors when they should actually be employees. Most businesses would rather have their workers as independent contractors because the employer is not responsible for payroll taxes and does not have to provide benefits to the contractors. But this is another hot-button issue for the IRS and if your business’s tax return shows a lot of money paid to independent contractors and not a lot of employees, the IRS may inquire. This is an easy audit target for them.

    The other issue with businesses using independent contractors is issuing 1099s. Generally, businesses must issue 1099s to their independent contractors if they earn $600 or more working for you during the year. Many businesses don’t, either because they don’t want to do the paperwork or don’t know the requirements. The IRS can assess penalties to businesses for not issuing 1099s when required to do so, so you want to make sure your business is in compliance in this area.

  4. Use of company automobiles. This is another area where there is a lot of manipulation. Corporations must be aware of the company auto use rules and have documentation to support their deductions. Here are the most common situations regarding company vehicles:

    • Company auto is used 100% for business – The employer may deduct 100% of the auto expenses and there are no income or payroll tax implications for the employees who use the auto.
    • Personal use of the company auto is permitted for commuting only – The employer is allowed to deduct 100% of the auto expenses, but must report an employee’s personal use of the vehicle on his or her W-2. The employee will recognize income on the personal (i.e. commuting) use of the vehicle at a rate of $3 per round trip.
    • Part business and part personal use of company auto – Like the commuting rule, the employer can still deduct 100% of the auto expenses, but must report income to the employee for his or her personal use. The issue that the employer has here is valuing the personal use of the vehicle. Generally, the personal use is valued at the amount the employee would have to pay to rent or lease the same or comparable auto under similar circumstances.

    Since reporting personal auto use to employees can be time-consuming and cumbersome, many employers do not do it. However, this is another common audit area for the IRS. Be sure to document auto use carefully and maintain a written policy regarding personal auto use by employees.

    TIP: If your company leases a car, there are special rules that must be followed when reporting auto expenses. If the vehicle has a fair market value of $15,500 or more (for passenger vehicles), or $16,400 or more (for trucks and vans), your company must report a certain amount in its income each year it leases the vehicle even if the vehicle is used 100% for business purposes. This is because most types of cars have limits on how much depreciation can be deducted on them in a given year, so the IRS wants to even the playing field with leased autos. They don’t want businesses leasing autos to avoid the vehicle depreciation limits. The amount of income the company should recognize is determined by using tables found in IRS Publication 463.

  5. Deducting miscellaneous expenses. If you look at the first page of a corporate tax return, you will see about 13 or 14 line items for different expenses such as salaries, rent, repairs, and interest. However, most businesses have more than this amount of expense items, so they have to submit supporting schedules with their tax return showing those expenses. One of the things the IRS will look for is the infamous, catch-all “miscellaneous expense” category. A lot of businesses will bury items in this category and it can be a big red flag to the IRS because they may think that you are trying to hide nondeductible expenses. Avoid the miscellaneous expense category if you can, and if you must use it, only report small, deductible expenses that truly are miscellaneous in nature.

    TIP: In lieu of categorizing such expenses under “miscellaneous expense” many business will report them under “office expense”. After all, every business will have some office expenses and the amount of items that could qualify as office expenses are endless. But the IRS will be on the lookout for businesses burying nondeductible expenses in the office expense category as well. Proceed with caution.

Disclaimer:  Any tax advice contained in this article is not intended or written to be used, and cannot be used, to avoid penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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