Karla Dennis, EA, MST, is CFO/CEO of the award-winning tax accounting firm KDA Inc.—specializing in tax planning.
Understanding what not to do is crucial to avoid an audit. Below, I’ll share several actions LLC business owners make that I’ve seen commonly trigger an audit and discuss how to avoid these red flags. Most people may think these are uncommon, but I actually see these often in audits.
Not Filing On Time
The No. 1 thing I’ve found cause an LLC audit is not filing taxes on time. Many entrepreneurs allow their LLCs to go year after year without filing a tax return, believing there wasn’t enough income to require filing or there was no income at all.
However, forming an LLC creates a filing requirement, whether income was made or not. Eventually, the IRS will issue what’s called a substitute for return, where the IRS files a return on behalf of the taxpayer based on aggregated information. Filing taxes every single year is essential.
Failing To Pay Estimated Taxes
Another reason LLC owners may get audited is failing to pay estimated taxes. Many people start LLCs without understanding filing requirements, including the need to pay quarterly estimated taxes. Failing to do so could result in a large tax bill at the end of the year, which often leads to a flagged return for audit.
The IRS recognizes that those who fail to file taxes on time likely do not understand how to report expenses and income properly, increasing the chances of misreporting. This prompts the IRS to flag returns for audit to ensure compliance.
Not Reporting Income
Failure to report income is another common audit trigger. Many believe that if they only made $5,000 and had $7,000 in expenses, they were at a loss and don’t need to report income. Others assume that not receiving a 1099 means the IRS is unaware of their earnings. However, the entity responsible for issuing the 1099 ensures that the IRS receives a copy for their own tax deduction purposes.
Failure to report all income can result in serious tax consequences, often triggering an audit. Typically, this leads to a CP2000 notice questioning unreported income. Ignoring this notice often results in further IRS action. Reporting all income as received is critical.
Overreporting Expenses
When running a business, all legitimate expenses incurred to generate income should be reported. IRC Section 162(a) states that all ordinary and necessary expenses can be deducted. However, excessive expenses with little or no income can raise IRS scrutiny.
If your return contains unusual expense-to-income ratios, consider including a statement acknowledging these circumstances. Anticipating IRS questions and addressing them in your return can be helpful.
Not Issuing 1099s To All Team Members
Another reason LLC owners get audited is not issuing 1099s to team members, including those working remotely from other countries, such as India or the Philippines. If people are working as part of your team, they must be issued a 1099, and backup withholding must be applied. Backup withholding requires withholding 30% of payments to foreign contractors and remitting that amount to the IRS on their behalf.
Rounding Your Numbers
Another common mistake is estimating expenses using rounded numbers such as $500, $2,000 or $5,000. Accounting almost never results in perfect round numbers, and the IRS recognizes this. Reporting actual expenses from checks, bank transfers and credit card statements prevents unnecessary scrutiny.
Bonus: Not Filing Tax Returns For Each Of Your Businesses
A final bonus tip: Setting up multiple LLCs and failing to file tax returns for them is another red flag when it comes to audits. Every LLC requires a tax return. If the LLC is no longer in use, it should be formally dissolved to eliminate filing obligations with the IRS.
Many LLC owners unknowingly fall into audit situations due to a lack of understanding the requirements. To protect yourself and your business, make sure you know the rules and avoid these audit triggers.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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