Whether your business is profitable or unprofitable, if it's been around long enough, chances are the IRS will eventually select yours for an audit. Of course, there are certain red flags that will definitely draw the attention of the IRS to your business and increase the chances that you will be audited. Being aware of these three big red flags can help minimize those chances.

Ensure information from one year agrees with information from the previous year. Each corporate tax return has certain items that carry over from one year to the next. For example, the cost-of-goods-sold section of the tax return contains beginning and ending inventory figures. The ending inventory from one year becomes the beginning inventory in the next year. Likewise, the ending retained earning in one year becomes the beginning retained earning in the next year. These items should agree from one year to the next. If they don't, it sends up a big red flag.

We often take on new clients who have had their prior tax returns improperly prepared. Consequently, we see items not matching from one year to the next. The IRS tracks these items and investigates when they don't match. You may as well have placed a note in your tax return that reads 'Audit me.' Consistency from one year to the next is the key.

These differences often come about when adjusting journal entries are made after the filing of a company's tax return. Small businesses often don't realize that changes to their accounting records after they've filed their tax returns means amended returns should be filed to account for these changes. The following year, they then begin by using the adjusted beginning balances without ever realizing that those balances don't agree with the ones on the tax returns that were filed. We recommend that all businesses have a competent CPA handle their tax and accounting needs.

Submit payroll taxes on a timely basis. Employers having financial problems sometimes don't remit payroll taxes to the government. Instead, the employers keep the payroll taxes and use them for their normal business operations—which is illegal. The government will go after business owners for the rest of their lives for this. You can't escape paying these taxes through bankruptcy or even closing down your business. You could end up being prosecuted criminally. We accountants can negotiate with the IRS, file the appropriate tax forms, even come up with an offer and compromise in an attempt to try to reduce the penalties and interest. However, the unpaid payroll taxes must always be paid. The sooner you get an accountant involved, the better.

Classify your employees correctly. Many companies love hiring independent contractors because they can pay them a flat fee without offering benefits such as health insurance, and they don't have to worry about withholding payroll taxes. The IRS, however, has a 20-point checklist to determine whether your worker is truly an independent contractor—or whether he is actually an employee and not an independent contractor. For example, do they come and go on their own schedule or are they required to work the hours that the business is open? Are they allowed to work for other companies? If you're disguising an employee as an independent contractor, the IRS will say this person should have been an employee and should have had taxes withheld. Since you paid him a gross amount and didn't withhold any taxes, they could assess you the amount of withholdings they figure should have appeared on each paycheck.

By being aware of these three red flags, you can greatly minimize your company's chances that it will be audited.

Rob Babek is a Stonefield Josephson Principal, CPA and business advisor. For more information about minimizing your firm's chances for an IRS audit, contact Rob Babek at 310-453-9400 or rbabek@sjaccounting.com.

 
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