by Tony Novak, CPA, MBA, MT updated July 17, 2015
I informally polled a group of tax professionals in the middle of 2015 about the income tax risks faced by small businesses thay they see in their own practical experience. Then I compared their responses with statements from IRS about historic collection actions and areas of priority for future audits to compile this list.
In evaluating and ranking the risks I considered: a) the likely number of small business violators, b) the historic number of audits, c) indication of future audits, and d) the amount of a typical audit settlement.
The top 10 tax risks faced by small business owners:
1. Misclassifying employees as contractors. This is #1 most common and potentially most expensive small business tax risk today. Not surprisingly, this area is the focus of the greatest number of IRS and state audits. Long term contractors are more likely to be recharacterized as employees under IRS rules and therefore are subject to wage taxes even if their work agreement says they a contractor responsible for their own taxes. IRS is now funding state audits on this issue that could trigger other costs like workers compensation coverage. Business owners may make the mistake of thinking that if a contractor works from home, uses her own equipment and sets her own hours then the business is not obligated to withhold wage taxes. That can be a costly mistake. On July 15, 2015 the Department of Labor issued new strongly worded guidance under Administrator’s Interpretation No. 2015-1 on this issue of worker misclassification. It is important for businesses to recognize that just because a worker is located in their own home or private office using their own computers and equipment, sets their own hours and is not supervised - this does NOT make them an independent contractor. Instead, look to the function of the worker's contribution in relation to the business to determing whether employee wage taxes are required.
2. Late or improperly calculated wage tax payments. 1 out of every 4 small firms pay these penalties. Often these can be avoided by switching to a better automated payroll processing system.
3. Improper reimbursements of health care expenses. This makes the list simply because of the size of the penalty at up to $36,500 per employee per year. New rules take effect on July 1, 2015 for small businesses that pay for individual health insurance or reimburse employee health care expenses outside of an integrated arrangement with a qualified group insurance policy.
4. Home office deduction. The number of these audits actually seems to rise each year even if that's not what IRS admits.
5. Under-reporting of income. This may be triggered by a missing 1099 or some other unintentional reason.
6. Undocumented travel mileage. (I personally have no experience with this issue but other tax professionals report frequent audits).
7. Improper reporting of inventory. This affects reported taxable income.
8. Unreasonable wages of S corporation owners. Earnings of an S corporation must be reasonably allocated between wages and shareholder dividends.
9. Improperly designed/executed deferred compensation arrangements. IRS recently issued new guidance to its agents and says that it will increase audits.
10. Improper handling of 401(k) plan contributions. Late deposits now trigger penalties
Of course knowing the risks is not enough. Each business, regardless of the diligence of its owners and tax professionals, has its own unique tax risk profile. Recognition and considerations to cope with these risks should be part of the strategic financial planning for every small firm.
A practical first step is to obtain a an analysis and a professional written second opinion to open the conversation. I would be pleased to discuss this type of short review under a flat fee service arrangement; please find more information here.
Opinions expressed are the solely those of the author and do not represent the position of any other person, company or entity mentioned in the article. Information is from sources believed to be reliable but cannot be guaranteed. Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues or a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. Tony Novak operates as an independent adviser under the trademarks "Freedom Benefits", "OnlineAdviser" and "OnlineNavigator" but is not a representative, agent, broker, producer or navigator for any securities broker dealer firm, federal or state health insurance marketplace or qualified health plan carrier. He has no financial position in any stocks mentioned. Novak does work as an accountant, agent, adviser, writer, consultant, marketer, reviewer, endorser, producer, lead generator or referrer to other companies including the companies listed in the articles on this web site.