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Avoiding the IRS Radar: Common Payroll & HR Compliance Audit Triggers

If you’re a small business owner, the idea of an IRS audit can strike fear into your heart. Small and medium-sized businesses, particularly those with fewer than 500 employees, are more likely to face audits. This is due to common compliance issues such as misclassifying employees as independent contractors, failing to adhere to wage and hour laws, or not providing required benefits. Misclassification alone can be a significant red flag for audits, as it has substantial implications for payroll taxes and benefits compliance.

As your company grows to 50 or more employees, there are more regulations to comply with, such as the Affordable Care Act (ACA) and the Family and Medical Leave Act (FMLA), which increases your audit risk. Smaller businesses may still face audits if they have specific red flags, such as a high proportion of independent contractors or frequent employee complaints about working conditions.

While it’s impossible to completely guard against an audit, if you understand the common red flags and maintain compliance with payroll and HR regulations, you can significantly reduce the risk to your business.

Common Reasons for IRS Audits

The purpose of an IRS audit is to ensure that the audited party isn’t avoiding federal and FICA taxes—commonly done by under-reporting or hiding income, over-reporting expenses or taking ineligible deductions, or misclassifying employees. The most common audit triggers for small businesses are discussed below.

  • Reasonable Salary

If you are an S-Corporation owner, paying yourself or other shareholder-employees an unreasonably low (or high) salary can trigger an audit. Determining a “reasonable” salary can be challenging, as the IRS does not determine a precise amount or range. The IRS interprets too-low salaries as an intention to avoid payroll taxes. As one example, if an S-Corp owner only takes enough pay to contribute the maximum amount to a traditional 401(k) tax-free, the risk for back taxes, fees, and penalties increases, unless the owner can prove the compensation was “reasonable.”

Reasonable compensation must be based on factors such as the owner or other shareholder-employee’s skill level, the size of the business, the industry, and other relevant factors. While the IRS doesn’t set a strict dollar amount, ensuring that compensation is justifiable is crucial to avoid scrutiny.

  • Shareholder Distributions

Shareholder distributions without reasonable compensation can also trigger an audit. If you’re making distributions to yourself and/or other shareholder-employees without paying reasonable compensation for services provided to the business, the IRS may see this as a way to avoid payroll taxes.

If your business can’t afford to pay reasonable compensation, it’s acceptable to forgo any compensation or shareholder distributions. You may also choose to pay just reasonable compensation but not take any shareholder distributions. Or you may choose to take a combination of reasonable compensation and shareholder distributions. However, if you opt for no compensation or shareholder distributions, and decide in the future to make retroactive distributions to yourself or other shareholder-employees, be aware that there may be additional costs. Retroactive distributions must account for fees during the same look-back period.

  • Employment Tax Compliance

Misclassification of employees is an extremely common trigger for audits. Businesses that classify many workers as independent contractors instead of employees can attract IRS attention, as this may be seen as a way to avoid payroll taxes, workers’ compensation, and liability insurance. Under IRS rules, a worker is an independent contractor only if they control their schedule, they control the work they perform, and they control the conditions under which they perform the work. If your business dictates these aspects, the worker is most probably an employee. Misclassifying workers can be extremely expensive, as it can result in back payroll taxes, fees, and penalties.

Non-compliance with HR regulations can result in significant penalties for your business, no matter its size. Many compliance regulations apply to all businesses, regardless of size. Compliance with these regulations is essential not only to avoid financial penalties but also to maintain a positive work environment and reputation. Read Compliance or Consequences: Key HR Regulations You Can’t Ignore to learn about specific HR non-compliance penalties.

In navigating the intricate landscape of payroll and HR compliance, small businesses face significant challenges that can lead to IRS audits and costly penalties. Misclassification of employees, inadequate compensation and other wage and hour practices, and issues with benefit provision are among the common triggers. While the risk of an audit cannot be eliminated entirely, proactively avoiding the pitfalls and keeping meticulous compliance with regulations can substantially lower your risks.

By partnering with experts like CRI Payroll Services, you can ensure your business operations align with federal requirements, safeguarding your business against noncompliance and potential audits. You’re free to focus your efforts on fostering business growth and success for your company.

Consider working with CRI Payroll Services and rest easy with our personalized and full payroll service. We take care of all the payroll needs including taxes, filings, and paperwork, so you don’t have to worry about staying updated on ever-changing laws. Plus, with our assistance, you can gain access to additional services, such as advice on human resources and benefits administration, that may help streamline your operations or save you money.

Contact CRI Payroll Services to learn more.