Think a tax audit won’t happen to you? Think again.
Every year, small businesses unknowingly make critical bookkeeping mistakes that put them on the tax authorities radar. Even an innocent expense deduction or a payroll error could trigger an audit. The worst part? If your records aren’t in order, you could face penalties, back taxes, and interest charges.
But here’s the good news: You can avoid it.
As a Certified Public Accountant (CPA) and bookkeeping expert, I’ve helped business owners keep their books audit-proof and tax compliant. In this blog, I’ll break down seven common red flags that could put your business at risk—and how to fix them before they become a problem.
Let’s dive in and make sure your finances are audit-ready!
1. Can You Really Deduct 100% of Your Vehicle? Here’s What the Tax Authorities Looks For
Many small business owners assume they can write off their entire car payment, gas, and insurance—but unless your vehicle is exclusively for business, this is a major red flag. The tax authorities know that most business owners use their cars for both work and personal purposes.
Example:
A self-employed consultant deducts 100% of their car expenses but also uses the car for personal errands. The tax authorities request a mileage log and finds personal use—leading to denied deductions and penalties.
How to Avoid It:
1 Keep a mileage log – Use apps like MileIQ or Everlance to track business miles.
2 Deduct only the business-use percentage – Example: If you drive 10,000 miles and 6,000 miles are business-related, deduct 60% of your car expenses.
3 Know the tax authorities rules – The standard mileage rate (2024: $0.67 per mile) is often easier than tracking actual expenses.
Pro Tip: Leasing a vehicle for business may offer better tax benefits than buying, depending on your situation.
2. Rounding Numbers or Estimating Expenses (Big No-No!)
If your books show rounded figures like $500 or $1,000 for multiple expenses, the tax authorities may assume you’re estimating rather than keeping accurate records.
Example:
A business owner reports $10,000 for office supplies, $5,000 for travel, and $2,500 for meals—all rounded numbers. This looks suspicious because real expenses rarely end in perfect zeros.
How to Avoid It:
1 Report exact amounts – E.g., $497.83 instead of $500.
2 Save receipts & invoices – Use Expensify or Dext to store digital copies.
3 Use accounting software – Tools like QuickBooks or Xero track expenses automatically.
Pro Tip: Using a business credit card for all transactions makes tracking expenses precise and easy.
3. Business or Hobby? Tax Authorities Rules You Must Follow to Avoid an Audit
If your business reports net losses year after year, the tax authorities may classify it as a hobby—meaning you lose your deductions.
Example:
A part-time photographer reports losses for five consecutive years. The tax authorities argues it’s not a real business since there’s no profit motive and disallows all deductions.
How to Avoid It:
1 Show intent to make a profit – Advertise, invest in marketing, and keep professional records.
2 Separate business & personal finances – Have a dedicated business bank account.
3 Follow the “3 out of 5 Rule” – Your business should be profitable in at least 3 out of 5 years.
Pro Tip: If your business isn’t profitable yet, document efforts to increase revenue—this can help justify deductions.
4. Employee vs. Contractor: Avoid Tax Authorities Fines with the Right Classification
Misclassifying workers to avoid payroll taxes is a big tax authorities red flag. If you control how, when, and where someone works, they’re likely an employee—not an independent contractor.
Example:
A salon hires a full-time receptionist but pays them as a 1099 contractor instead of an employee. The tax authorities audit the business and demands back payroll taxes, penalties, and interest.
How to Avoid It:
1 Follow the tax authorities Common Law Test – Consider behavioral, financial, and relationship control.
2 Issue W-2s for employees and 1099-NEC for contractors.
3 Consult a payroll expert – Avoid costly mistakes.
Pro Tip: If unsure, err on the side of caution—misclassification penalties can be severe.
5. Excessive Charitable Donations (Red Flag for the tax authorities)
Donating to charity is great, but if you’re claiming large deductions relative to your income, the tax authorities may question whether they are legitimate.
Example:
A sole proprietor earning $60,000 per year claims $30,000 in charitable contributions—this is 50% of their income, which is unusually high.
How to Avoid It:
1 Keep official receipts from charities – A bank statement isn’t enough.
2 Know tax authorities deduction limits – Individuals can deduct up to 60% of adjusted gross income (AGI) for cash donations.
3 If donating property, get an appraisal – Make a filing for non-cash contributions over $500.
Pro Tip: The tax authorities may disallow your deduction if it’s disproportionate to your income.
6. Large Cash Transactions & Underreported Income
The tax authorities receives copies of 1099s, W-2s, and bank statements—if your reported income doesn’t match, expect scrutiny.
Example:
A freelancer receives a 1099-NEC for $75,000 but only reports $60,000 in income. The tax authorities sees the discrepancy and flags the return for further investigation.
How to Avoid It:
1 Report ALL income, including cash payments.
2 Cross-check tax returns with 1099s and W-2s before filing.
3 Use bookkeeping software to track all revenue sources.
Pro Tip: If you make a mistake, file an amendment ASAP rather than waiting for the tax authorities to catch it.
7. Overstating Business Deductions (Tax Authorities Watches This Closely!)
Business deductions must be reasonable. If your deductions seem too high compared to your income, the tax authorities may take a closer look.
Example:
A small business owner reports $50,000 income but deducts $40,000 for travel expenses—which is unusually high.
How to Avoid It:
1 Only claim legitimate, necessary, and ordinary expenses.
2 Keep detailed receipts and explanations.
3 Compare deductions to industry benchmarks.
Pro Tip: If an expense seems unusually high, ensure it’s well-documented.
Want to Eliminate Audit Stress? Get a FREE Consultation Now!
At Tactic Bookkeeping, we help small businesses stay tax compliant, avoid audits, and maximize deductions—without stress.
Book a FREE consultation today!
Click here: https://tacticbookkeeper.com/contact/
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What’s Next?
Which red flag surprised you the most? Let’s discuss in the comments!