We are seeing an increase in the IRS auditing corporations. There are a number of reasons why the IRS will choose a particular corporate tax return for an audit – here are some common triggers that can help you stay off the IRS radar:
Payroll, payroll, payroll
The IRS is well aware that many businesses give in to the temptation of using payroll tax money for operating expenses. Payroll taxes are your employees’ share of federal tax, FICA and Social Security/Medicare and these amounts do not belong to your business. The funds must be safeguarded and when due, turned over to the federal government.
The IRS will also scrutinize attempts to circumvent payroll altogether. For example, substantial loans to corporate officers with correspondingly low payroll figures is a red flag – it may indicate that the company is engaged in an abusive scheme to avoid payroll taxes. In these cases, the IRS may re-characterize officer loans as payroll, with significant tax, interest and penalties imposed on the company. Note also that the IRS may also look for a 1099-Int to confirm that the corporation received interest on all loans paid to an officer.
Excessive and unauthorized deductions made on a corporate tax return
A corporate tax return may be selected for audit on the basis of a computerized numeric score that is outside the statistical norm, as generated by the Discriminate Function System (DIF). Deductions for meals, travel, automobile expenses, business entertainment, charitable donations, salaries/bonuses, health insurance and other fringe benefits that are out of proportion will give the company a higher score, resulting in the IRS giving it a more careful look.
Personal expenses billed to the company
The IRS is watchful of the following:
- Corporations that include an officer’s personal use of a leased vehicle on their W-2.
- Contractors that bill their companies for improvements made on their personal residences.
Make sure that all meals, travel, entertainment and the like that are billed to the company satisfy the “business purpose test” – if there is no substantial business purpose to the transaction, the deduction will be denied.
Poor recordkeeping
Poor recordkeeping can easily lead to an IRS audit. If the corporate books don’t balance, the tax return entries won’t balance. W-2 forms and 1099 interest statements need to match income reported on the tax return. Retained earnings must be rolled forward to the next year. A retail business should not show an unreasonably low ending inventory. A company should have a good reason for any significant deviation in its profit margins and expense ratios from previous years. These are all red flags for the IRS that show a lack of attention to detail and/or possible absence of records to substantiate the company’s expenses.
Tax forms not timely filed
The IRS will question the accuracy of your books if any of your tax forms are not filed in a timely fashion. This includes:
- Annual 1120 U.S. Corporation Income Tax Return
- Annual 940 Employment Tax Return
- Form 941: Employer’s Quarterly Federal Tax Return
- 1120-W Estimated Tax for Corporations
- 1096 Annual Summary and Transmittal of U.S. Information Returns, along with 1099s
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