The Top 5 IRS Red Flags for Small Business

When it comes to running a business, one of the last things you want is to attract the attention of the IRS. Unfortunately, certain common tax mistakes can raise red flags, putting your business at risk of an audit or penalties. As a small to medium-sized business owner, it’s essential to be aware of these pitfalls to avoid unnecessary complications with your taxes. 

In this post, we’ll cover five key IRS red flags that you should watch out for and insight into how to keep your business in the clear. Let’s dive into the top mistakes business owners often make and how to prevent them from triggering an audit. 

1. Unreasonable Compensation for S Corporation Owners

One of the most significant red flags for the IRS involves S Corporation owners who do not pay themselves a "reasonable" salary. When you run an S Corporation, it’s tempting to minimize your payroll to avoid paying Social Security and Medicare taxes, but the IRS is closely watching.  

An owner must pay themselves a fair wage for the work they do. If the IRS suspects that you’re not paying yourself enough or are skipping payroll altogether while taking large profit distributions, they might reclassify your distributions as wages. This can lead to back payroll taxes, penalties, and fines. 

The bottom line? Make sure you're compensating yourself fairly, following industry standards, to avoid being audited. 

2. Earned Income Tax Credit (EITC) Abuse

The Earned Income Tax Credit is a common red flag, especially for small business owners or sole proprietors with self-employment income. This refundable tax credit is designed for low-income individuals, particularly those with dependents. Since the credit is refundable (meaning the IRS can pay you even if you owe no taxes), it’s heavily scrutinized. 

Some people try to game the system by misreporting income, claiming ineligible dependents, or manipulating self-employment earnings to qualify for the maximum credit. This is one of the most common sources of audits for self-employed individuals. 

To avoid this red flag, always ensure your dependents and income reporting are accurate and honest. 

3. Recurring Losses on Schedule C 

If you’re self-employed and continuously report losses on your Schedule C (the tax form for sole proprietors), expect the IRS to take notice. Reporting losses year after year raises questions about whether your business is truly a business or just a hobby. 

While businesses can—and do—experience losses, the IRS typically becomes suspicious after three years of consecutive losses. If they suspect your business is a hobby and not a genuine attempt to make a profit, they may disallow deductions, leading to higher tax bills. 

Keep detailed records and be prepared to demonstrate that your business is legitimate, and your losses are valid. 

4. Imbalanced Itemized Deductions and Income

If you claim itemized deductions that significantly exceed your reported income, the IRS may flag your return for review. Deductions for state and local taxes, mortgage interest, and charitable donations should be in line with your income level. For example, if you’re reporting minimal income but making large charitable donations, the IRS will question where the money is coming from. 

Inconsistent deductions and income are a red flag because they often point to unreported income or other financial inconsistencies. Make sure your itemized deductions are realistic and well-documented. 

5. Omitting Income

One of the simplest yet most dangerous mistakes is omitting income on your tax return. Whether it’s intentional or accidental, failing to report all your income will likely result in a matching error when the IRS cross-checks your reported income with W-2s, 1099s, and other documentation. 

If you realize you've forgotten to report income, it’s best to file an amended return before the IRS catches the mistake. Waiting for them to notify you can put you on their radar, increasing your chances of facing further scrutiny in the future. 

Conclusion: Avoid IRS Red Flags and Keep Your Business Safe 

No one enjoys dealing with the IRS, and the best way to avoid their attention is to be proactive in managing your taxes. Make sure your compensation is reasonable, your deductions are accurate, and your income is fully reported. By avoiding these common red flags, you’ll minimize the risk of an audit and keep your business running smoothly. 

If you're concerned about any of these issues or want a second opinion on your tax strategy, reach out to Kaizen CPAs. Click the "Let’s Chat" button to schedule a consultation and find out if we’re a good fit to help you navigate the complex world of tax compliance.