Let’s paint a picture: You file your S Corp tax return. Then, you receive a certified letter in the mail from the IRS. You’re being audited. 

Did your heart just leap into your throat at the thought?

For many business owners and individuals, an IRS audit is a major inconvenience at best and a nightmare at worst. Even if you’re not intentionally violating any tax requirements, the way you have your single owner S Corp and payroll processes set up could still trigger an audit. So, what can you do to prevent your business from throwing up red flags for the IRS?

Here, we’ll provide you with four top audit triggers for S Corps. Armed with this post, you should have all the information you need to run your business and taxes in a way that doesn’t cause you to run into trouble with the IRS. 

S Corp Audit Risk: The Likelihood of Being Audited

Business owners are often concerned about their audit risk. So, let’s start with some basic statistics: What is the likelihood of getting audited as an S Corp owner? Historically, S Corp owners were audited at the low rate of 0.05 percent. 

However, starting in 2021, the IRS began to prioritize auditing S Corporations and partnerships, meaning your likelihood of being selected for audit has increased in recent years. Your S Corp is still less likely to be audited than a C Corporation. C Corps with less than one million dollars in assets are audited at a rate of around one percent. This rate increases significantly as the corporation’s total assets increase. 

Related: Payroll Tax vs. Income Tax: What's the Difference?

Should your S Corp fail an IRS audit, you will face fines at a minimum. Depending on the severity of your record-keeping impropriety, you could also face criminal charges and up to one year of jail time.

In short—you want to avoid attracting an IRS audit. Let’s dive into four actions or practices that might attract the attention of the IRS and flag your S Corp for an audit. 

1. Low or Nonexistent Shareholder Salaries 

A vital step in setting up your S Corporation is setting a reasonable S Corp salary for yourself. If you over-estimate your reasonable salary, you might end up over-paying in taxes, but if you underestimate, you may just find yourself in the IRS’s crosshairs for an audit. 

So, how can you set the perfect salary? Base your payment on the IRS salary guidelines: 

1. Qualifications: Consider your education and experience.
2. Scope of Duties: Consider your job duties. 
3. Time Worked: Consider your usual schedule.
4. Size of Business: How many employees do you employ?
5. Economic Conditions: Consider the overall conditions of the economy at large. 
6. Whether Salary is Predetermined: Do you plan to set your salary upfront or pay yourself only after the end of the tax year based on earnings?
7. Prior Salaries: Consider your previous salaries or the salary you paid yourself in previous years. 
8. Salaries of Other Employees: Do you have other employees? Consider their salaries when setting your own. 
9. Comparable Salaries: Consider salaries for comparable roles at similar organizations. 

Setting the proper salary for yourself will drastically reduce your risk of IRS audit come tax season. 

2. Excessive Expenses and Deductions 

The second way to raise a flag for the IRS when managing your S Corp is by claiming excessive expenses or deductions. 

As a business owner, you can claim tax deductions on your home office or vehicle if used for business. Additionally, you can reimburse yourself for meals or travel undertaken for business-related reasons. However, if you overuse these expenses and deductions, the IRS may decide they want to take a closer look at your S Corp.

Related: 4 Ways to Maximize Savings with Pre-Tax Deductions

When claiming your Home Office Deduction, remember that this deduction only applies to your home used exclusively for business square footage. If your office doubles as a guest room, you should not claim deductions for that space.

Vehicle Deductions should also be approached with caution. Ensure that you do not claim full business use unless you genuinely never use your car for anything other than your business.

Lastly, record-keeping is vital when you’re claiming Meal and Travel Expenses. Save receipts and maintain a document with the purpose of the trip or meal, a list of everyone in attendance, and the minutes from any meetings that occurred. 

3. Tracking Cash Payments

Does your S Corp conduct a significant percentage of business via cash payments? If so, it is not inherently a red flag, as many freelancers receive cash payments. However, the challenges associated with tracking cash payments may encourage the IRS to take a second look at your S Corporation.

Additionally, if you receive cash payments over ten thousand dollars, you must file IRS Form 8300. 

Limit your cash payments by investing in a tool like a Square Card Reader if possible to lower your IRS audit risk. If you cannot transition away from cash payments, ensure you have robust tracking methods in place to help you demonstrate the legitimacy of those payments to the IRS if you get audited. 

4. Discriminant Function (DIF) Score 

The last factor that may trigger an IRS audit of your S Corp is a bit of an enigma: The Discriminant Function (DIF) Score. 

The DIF Score is the IRS's algorithm to determine whether they should audit a tax return. The specifics of how the IRS calculates this score are a tightly-guarded secret, but we do know a couple of the criteria used:

1. The ratio of your income to certain expenses
2. A comparison of the current year’s tax return to prior years’ returns

Though it’s challenging to counter an algorithm you don’t have full insight into, it is still helpful to be aware of the DIF Score’s existence when attempting to operate your S Corp in a manner that does not invite an audit during tax season. 

The Easiest Way to Lower Your S Corp Audit Risk

Keeping an eye out for these triggers helps you conduct your S Corp’s business in a way that will keep you off the IRS’s audit list. However, keeping all of these elements in order while still running your business can be a challenge. 

If you want to lower your S Corp audit risk and save time on payroll and tax processes, consider partnering with a payroll provider. 

ConnectPay can help you avoid running into challenges related to taxes and payroll down the line. Schedule a call with a Connected Service Representative today to see how we can help you lower your S Corp audit risk!