Protect against an IRS audit when you file small-business taxes

Your small- or home-based business can legally reduce its federal income tax liabilities without increasing the odds of an IRS audit. In my twenty-five years of practicing law—including time spent as an attorney for the IRS—I have seen many common mistakes small businesses make. Mistakes increase the odds of an IRS audit, and also increase the amount of taxes they will ultimately pay.

Some of the common mistakes include choosing the wrong business entity, improperly conferring benefits on the business’ owner, paying either too little or too much compensation, not properly classifying workers as employees or independent contractors, not planning to avoid hobby losses and passive activity losses, not claiming the home office deduction, and overlooking or not properly documenting legitimate business expenses.
This article will address just a few of the many common mistakes business owners make with their taxes, and how you can avoid making such mistakes—protecting yourself and your small-business from an IRS audit.


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  • choose the right entity when forming a business
  • pay yourself a reasonable amount of compensation
  • properly classify workers as employees or independent contractors
  • claim all tax-deductible business expenses
  • consider hiring a qualified tax professional

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  • let any losses you incur be disallowed as hobby losses
  • let your losses be disallowed as passive losses
  • overlook the home office deduction
  • forget to keep proper records
  • promote extra scrutiny on your tax return

Scott M Estill‘s recommendation to ExpertBeacon readers: Do

Do choose the right entity when forming a business

You have a number of choices when it comes to deciding how you (legally) wish to do business. These choices generally include a sole-proprietorship, a general or limited partnership, a limited liability company, an S corporation, and a C corporation. The entity you choose will depend on tax, asset protection, and estate-planning considerations.

For instance, if you would like to avoid personal liability for the debts of the business, a limited liability company, S corporation, or C corporation may be appropriate. Also, if you want to make sure that the business pays its own tax liabilities (and they are not reported and paid on your personal income tax return), you would need to choose C corporation taxation.

Other factors to consider may include recordkeeping and meeting requirements, whether or not you anticipate investors and your desired opportunity for growth. You should discuss your circumstances and goals with an attorney before deciding upon an entity for your business. It is important to understand that the IRS audits business entities such as a limited liability company, partnership or corporation on a much-less frequent basis than it does personal tax returns (and personal tax returns which list a sole proprietorship business on the return).

Do pay yourself a reasonable amount of compensation

Compensation for personal services is a deductible business expense if it is “reasonable” in amount. This issue comes into play with all S and C corporations and planning must be done to maximize any potential tax savings. For instance, an owner-employee of a C corporation may want to pay compensation to him/herself that is on the “high” side to reduce the taxable income of the C corporation. Likewise, an owner-employee of an S corporation may want to pay compensation on the “low” side to minimize the amount of employment taxes that would need to be paid.

To avoid a determination by the IRS that compensation is either too high or too low, five factors should be considered when deciding upon an employee’s compensation:

1. The employee's role in the company (nature of work and job duties);
2. A comparison of the employee's salary with those paid by similar companies for similar services in a similar geographic area;
3. The character and financial condition of the company;
4. The pay history, education and skill/ability of the employee; and
5. The internal consistency of salaries paid to all employees of the company.

Do properly classify workers as employees or independent contractors

If you mis-classify an employee as an independent contractor, you may later find yourself with an unexpected employment tax audit and subsequent tax liability. This is a very common business audit issue and should be guarded against.

In general, an employee is a person hired by a business which has the right to direct and control the employee and tell them how the work is to be performed. An independent contractor, on the other hand, is a person or entity who provides services to the general public and is not subject to another person’s control.

Some of the important factors to consider in making this determination are (1) the degree of control the business has over the details of how the work is performed, (2) whether or not the business furnishes equipment, facilities, or helpers to the worker, (3) the right to discharge the worker, (4) whether the duties performed are an integral part of the business, (5) the permanency of the relationship, and (6) the relationship the parties thought they created as evidenced by how the worker was treated for tax purposes.

If you are unsure whether a person doing work for you is an employee or an independent contractor, you should consult with a tax attorney.

Do claim all tax-deductible business expenses

It is important to claim all of one’s deductible business expenses. These expenses are ones which are ordinary, necessary, and reasonable with respect to the operation of the business. As long as you can demonstrate how the expense helped the business (and what the business purpose/justification of the expense was), you can claim a valid tax deduction and legally reduce the taxable income and amount of taxes that are required to be paid.

These expenses may include automobile, travel, meals and entertainment, advertising, salaries, depreciation, supplies, retirement plans, fringe benefits, telephone, utilities, home office, rent, insurance, legal and professional and numerous other possibilities. Here are two common expenses that are often misunderstood:

Business Clothing: To be deductible as a business expense, the type of clothing must be required or essential in the person’s employment. In addition, it cannot be suitable for general or personal wear, and not actually worn as ordinary clothing. For instance, a firefighter’s suit would be deductible as business clothing, but a TV news anchor’s suit is not deductible as business clothing because it can be worn outside of work as ordinary, personal clothing.

Educational Expenses: Expenses for education that maintains or improves skills required by an individual in his or her employment or other trade or business are deductible as business expenses. However, if the expenses are incurred to meet the minimum education requirements for qualification in a taxpayer’s trade or business, or qualify the taxpayer for a new trade or business, they are nondeductible.

Do consider hiring a qualified tax professional

Tax laws are complex, and with a small/home-based business on top of possibly another job or other income-producing activity, the paperwork and forms can be difficult at best for anyone not well-versed in the tax laws. If you are not sure that you are claiming all tax credits and deductions, and otherwise reducing your overall taxable income, you may want to consult with a tax professional. The business portion of this consultation is also tax deductible for a business!

While utilizing a tax professional will cost you more upfront than doing it yourself, you will have a professional on your side who knows what they’re doing, can provide support on the possibility that you are audited, and give you peace of mind with your taxes being properly prepared and filed.

Scott M Estill‘s professional advice to ExpertBeacon readers: Don't

Do not let any losses you incur be disallowed as hobby losses

If an activity is found to be a hobby (i.e. you did not engage in your activity with an intention to make a profit), the IRS will disallow any losses generated by the activity. Thus, you must make sure that your activity is a “business” and not a “hobby” under the tax laws. There are nine factors the IRS uses to determine whether or not an activity is engaged in for profit.

These are: (1) the manner in which the person carries on the activity, (2) the expertise of the taxpayer or his or her advisors, (3) the time and effort expended by the taxpayer in carrying on the activity, (4) any expectation that the assets used in the activity may appreciate in value, (5) the success of the taxpayer in carrying on other similar or dissimilar activities, (6) the taxpayer’s history of income or losses with respect to the activity after its start-up phase, (7) the amount of occasional profits, if any, which are earned, (8) the financial status of the taxpayer, and (9) any elements of personal pleasure or recreation in the activity.

With some planning in light of these factors, it is possible to make the appropriate changes to an activity to reduce the likelihood that the IRS will classify it as a hobby. You may also find that your audit chances will be greatly reduced if you use a business entity as opposed to filing a Schedule C on your personal tax return for the business’ income and expenses.

Do not let your losses be disallowed as passive losses

Losses incurred by individuals, estates, trusts, closely-held C corporations, and personal service corporations in passive activities may not be used to offset other income under the tax laws. If an owner does not materially participate in the conduct of a trade or business, it will generally be classified as a passive activity. Material participation is regular, continuous, and substantial involvement in the business operations. Passive activities are often found in the context of rental real estate, long-term equipment leases, and many other activities in which the investors do not participate in the business activities. Also, all rental real estate activities are generally passive whether or not the owner materially participates.

The IRS has issued regulations which provide circumstances under which a taxpayer will be treated as materially participating in an activity. Under these IRS regulations, a taxpayer who meets one of seven safe harbors will be treated as materially participating in an activity for the taxable year. The safe harbors include participating in the activity for more than 500 hours during the year, doing substantially all of the work in the activity, and participating in the activity for more than 100 hours—and more than any other individual who participated in the activity.

There are exceptions to the general rule that rental real estate activities will be characterized as passive activities. These exceptions are for real estate professionals and for individuals who are active participants in rental real estate activities. If you would like additional information about passive activities, consult with a tax attorney or CPA who is very familiar with the complexities of real estate losses (these are governed by Section 469 of the Internal Revenue Code—a confusing section if there ever was one!).

Do not overlook the home office deduction

A deduction may be claimed for business expenses related to the portion of a dwelling unit used exclusively, and on a regular basis, as either (1) the principal place of a business, (2) a location to meet customers, clients, or patients, or (3) a separate structure in connection with the business.

If there is any personal use of the space, no deduction will be allowed. To determine if an office is the principal place of business, it is necessary to look at the relative importance of the activities performed, and the amount of time spent, at each business location.

An office will qualify as the principal place of business if the owner of the business performs administrative or management activities there and at no other fixed location. Also, one home office may be the principal place of business for more than one business that the person conducts from that office. This can be a valuable way to capture tax deductions for expenses that you are already incurring, such as rent, utilities, insurance, HOA dues, etc. In addition, it no longer will trigger a tax audit, so claiming the home office deduction is not an audit red flag.

Do not forget to keep proper records

It is important to keep and retain adequate records to establish your income and deductions. Expenses may be substantiated by providing receipts, a diary or account book, a mileage log, or a calendar. Some expenses require a higher level of substantiation. These expenses include deductions for meals, entertainment, travel expenses, gifts, passenger vehicle expenses, and expenses for computer equipment. These expenses require adequate records or other evidence to show (1) the amount of the expense, (2) the time and place of the travel or use of the property, (3) the business purpose of the expenditure, and (4) the business relationship to the taxpayer of the person(s) entertained, using the facility or property, or receiving the gift. If at all possible, these records should be made at or near the time the expense was incurred.

Do not promote extra scrutiny on your tax return

While the overall IRS audit rate is low (relative to other years in the recent past), there are some red flags that can increase your overall income tax audit rate.

In no particular order, these can include: (1) filing a schedule C (Sole Proprietorship) with your Form 1040; (2) claiming 100% business use of a personal vehicle; (3) running a cash-intensive business (such as a car wash, tavern, taxi, etc.); (4) deducting large meals and entertainment expenses (and often lacking the necessary records to prove the expenses during an audit); (5) deducting potential hobby losses; (6) deducting rental property tax losses when a real estate professional status is claimed; (7) failing to report offshore bank accounts; (8) improperly claiming a stock market trader status; and (9) taking higher than average itemized (Schedule A) tax deductions.

There are, unfortunately, many other potential audit triggers, along with the fact that the IRS does purely random audits every year (so nothing you did but for filing a tax return triggered the audit).


If you establish your small/home-based business under the proper entity and run it in such a way that you appropriately compensate yourself for your time worked, properly classify your workers, and maximize all business tax deductions—you are on your way to having a smooth tax season.

As you prepare your taxes, keep thorough records of all your expenses as some require more explanation and information than other expenses, and don’t forget about all possible tax deductions. Such practices will help you reduce your overall income tax liabilities and minimize your chances of an IRS audit. Always keep in mind the complexities of the tax laws, and if necessary, consider going to a tax professional who will help you file your taxes with peace of mind.

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