Certain mistakes flag your business as an audit target, opening the door to a slew of negative consequences your business would be better off avoiding. They include:
It’s the letter nobody wants to receive: The IRS has questions about your business’s tax return and kindly invites you to join them in an audit. Your participation is mandatory.
You can’t help but wonder, “Is there anything that could have prevented this from happening to my business?”
Sometimes the answer is no; IRS audits can be random. But often, red flags on your tax return signal that there may be a reason to look deeper. You can significantly reduce the odds of unwelcome attention from the IRS by avoiding these five common business tax mistakes that make you an audit target.
Partnership agreements and C-corporation shareholder agreements are precisely worded and legally binding arrangements. Particularly, partnership agreements specify how income and losses are treated and distributed among all partners based on the amount and nature of the income. Errors often arise when partners forget (or never knew) what the agreement dictates. Tax advisors can help you keep everything on track, but only if they have access to the documents and have been provided with a complete and correct explanation of the arrangements. This doesn’t always happen.
Audit risk rises for a private equity fund, investment partnership or professional services firm taxed as a partnership when the IRS can’t reconcile K-1 tax reporting with the allocation model defined in your governing documents. These errors may not surface until years later and when they do, they can lead to costly reallocations, partner disputes and amended returns. If the relevant deadlines have passed, your ability to claim valuable tax credits or other incentives on an amended tax return will likely be severely limited and you could owe much more than you would have to begin with.
It's important for everybody involved — owners, accountants, the finance team, CFOs, controllers and everybody else who's involved with income allocations — and the outside tax advisors to be on the same page. Everyone should be checking this information on an annual basis, to make sure it all aligns with the partnership agreement.
Basis is a simple concept in theory. It’s the amount of investment you’ve made into the entity plus the income you’ve earned, less the cash you’ve taken out and any losses. But if you don’t track basis carefully, it can become extremely complex. Basis becomes highly relevant with tax planning for partnerships and S-corps-since these entities are subject to some unique rules around non-recourse indebtedness for real property. It gets even more complicated for businesses like real estate or construction companies that make large capital investments or seek capital infusions from shareholders, partners or external sources.
Shareholders and partners who receive a K-1 often inadvertently claim losses when they don’t have sufficient tax basis. This creates a mismatch between entity reporting and what owners claim on their tax return. It’s one of the easiest things for the IRS to challenge, and one of the most common places taxpayers get it wrong. When the IRS flags it as an error, the required changes may go back many years for the individual partners involved.
It helps to have basis centralized year over year. It should be tracked at the partner level, but entities could also provide this information for their partners. Whether it's done by the entity, by accountants for the entity or by the accountants for the individual, it’s essential to track basis each year.
Inadequate basis tracking is far from the only reason why data mismatches occur. It can happen for many reasons, including reliance on manual adjustments or spreadsheets without audit trails to create visibility into underlying accounting processes. Timing is another common cause. K-1s that aren’t due until September 15 (with the extended filing date) may flow to another partnership or S-corp that faces the same tax deadline. In the rush to get everything completed for timely filing, it’s easy to overlook updating estimated numbers once final reporting comes through.
Whatever the cause, it’s a big problem if your tech startup’s K-1s, financial statements and filed returns don’t reconcile cleanly. The IRS is increasingly data-driven, and differences between partner reporting and entity reporting are a growing focus of the agency’s data analytics. If the numbers don’t match across filings, you’re waving a red flag.
Proactive communication is essential to identify when K-1s will be ready and holding people accountable to timely deadlines. If the information isn’t available, where the option is available, amend your return or take other corrective actions to capture the proper information after the fact. Include an explanation saying you’re providing final information that wasn’t available when you filed originally.
Companies frequently underestimate the complexity of state tax requirements, especially in the post-Wayfair era. Each state sets its own thresholds for nexus, and frequent changes to these rules make it difficult to comply with current state-level regulatory requirements. State and local tax authorities may consider revenues, transaction volume, wages, assets and more to determine sales and use tax obligations, income or franchise tax exposure and whether remote workers trigger withholding, unemployment or registration requirements.
Your manufacturing business may have nexus in multiple states, and an expanded tax footprint can happen without anyone noticing. If you’re not aware of your obligations in every jurisdiction, you could be noncompliant. You’ll owe the taxes due since nexus was first established, plus penalties and interest. But by then, you may not be able to take advantage of tax incentives or claim a deduction in your home state for the tax you’re paying to others.
It’s critical to meticulously track where you’re generating revenue and consult with knowledgeable tax experts before you expand into new jurisdictions. Our advisors can research compliance requirements and help you minimize your overall tax obligations as you expand. That’s particularly important if you’re operating in a high-tax jurisdiction state like California or New York; a strategic approach can often help businesses apply the correct sourcing and apportionment rules and avoid over- or under-attributing income among jurisdictions.
It’s tempting to claim a tax credit that you think you qualify for, but if you can't defend it with documentation, you can’t sustain it in an audit. When the IRS asks for more information about a tax incentive you’ve claimed or on any other tax position, you should be able to respond quickly. An optimal package of information supports everything you’ve claimed with detailed schedules, labeled and cross-referenced. All the numbers should match to the dollar with what you reported on your tax return.
Say your pharmaceutical company develops an improved process you use for your new injectable drug, qualifying you for an R&D tax credit. Your claim will likely hinge on contemporaneous records detailing the goals of the project including hours devoted to it, materials used and employees who performed the work.
If you don’t keep clear, well-organized records year-round, you may struggle to provide this kind of documentation quickly. And the longer you scramble to put it all together, the more agents may believe your records weren’t created contemporaneously, and that you're trying to support items after the fact.
Talk with your tax professional proactively about the kind of documentation you need to keep for any potential tax incentives and prioritize keeping detailed records across all business activities. Having good records lends confidence that you can respond quickly to an inquiry and makes your claim more defensible. You’ll be in a stronger position to keep an inquiry from turning into an audit or discourage the IRS from expanding the scope of your audit.
Responding quickly to an IRS notice is imperative, but you can reduce the chances of receiving one in the first place by avoiding these common audit triggers. Our tax experts can show you more best practices and business strategies to keep you in compliance and out of IRS crosshairs, while de-risking any agency engagement that does occur.
Get a free one-on-one consultation to assess your needs and next steps to help you reach your strategic tax goals.
