7 Red Flags that Trigger IRS Audits for Small Business Owners

May 23, 2023

Contractors need to be aware of the potential red flags that could result in an IRS audit or penalties from other regulatory agencies. Misclassifying workers as independent contractors rather than employees, not understanding applicable sales taxes, making errors in reporting income, performing unpermitted work, having inadequate record-keeping practices, failing to document cash transactions, and not having adequate insurance are all issues that could lead to penalties or fines.

What Are the Biggest Red Flags That Trigger an IRS Audit?

Wondering How to avoid an IRS Audit? What mistakes people make that trigger IRS audits? What leads to an IRS Audit? Why do people get audited by the IRS?

Contractors may unknowingly commit fraud or operate illegally due to a lack of knowledge, oversight, or understanding of the complex regulations governing their industry.

The last thing any business owner wants is to get hit with an IRS audit.

The IRS has some advice about audits here, and they have a guide about IRS triggers and tips, and other articles are here, here and here.

San Francisco California Based Audit Representation & IRS Audit help
Shamal & Rachel Asnani - Owners of Asnani CPA Tax & Accounting

Here are some ways a contractor might unwittingly commit fraud or operate illegally:

7 Red Flags that Trigger IRS Audits for Small Business Owners

Red Flag #1: Misclassification of Workers

Misclassification may lead to penalties and fines enforced by tax authorities and labor departments.

Misclassifying employees as independent contractors is a common mistake made by contractors, which can result in underpayment of payroll taxes, employee benefits, and workers' compensation premiums.

As a small business owner, it's important to understand the difference between an employee and an independent contractor and properly classify workers to avoid these issues.

Red Flag #2: Ignorance of Sales Tax Laws

Contractors might not always possess a comprehensive understanding of the sales tax laws in their region, which can result in non-compliance, and lead to costly penalties.

Which is why they need an outsourced accountant to do their taxes for them.

We are an accountant who provides bookkeeping, tax reduction planning, and payroll for small California businesses.

It is important for contractors to be proactive in educating themselves about sales tax laws and ensuring that they are in compliance with all relevant regulations.

Red Flag #3: Unintentional Errors in Reporting

Accurate financial reporting is critical for maintaining compliance with tax regulations.

Inaccurate financial reporting is often unintentional and caused by errors or a lack of understanding of such regulations.

Subsequently, the repercussions of tax fraud include enormous tax bills, expensive civil and criminal penalties, damage to the reputation of the company, and imprisonment.

It is crucial for businesses to take a proactive approach to avoid making erroneous financial mistakes that could lead to tax fraud charges.

One way to mitigate this is to hire an accountant.

Red Flag #4: Unpermitted Work

It is common for contractors to operate in various jurisdictions, with each having its own unique regulations regarding permits, licenses, and inspections.

The failure to understand and comply with these local regulations could result in contractors performing their work without the required approvals, leading to financial penalties, fines, and potential legal action.

Clients may be hesitant to work with a contractor who has a history of violating rules and regulations.

Not obtaining proper permits, licenses and inspections can pose a significant danger to the safety of the worksite and surrounding community, resulting in property damage, injuries or worse.

Red Flag #5: Inaccurate Record-Keeping

Maintaining comprehensive and accurate financial records is paramount for a business to operate efficiently and effectively.

Poor record-keeping practices can lead to incomplete or inaccurate financial records, which can result in serious consequences, including tax audits, inquiries, or investigations.

Inaccurate or incomplete financial records can result in difficulties substantiating expenses, deductions, or income during an audit.

Tax authorities, or the IRS, require extensive documentation to support any claims made in tax returns.

Business owners are encouraged to seek professional advice on how to improve their record-keeping practices and stay compliant with the applicable tax laws and regulations.

Red Flag #6: Not Reporting Cash Transactions

Some contractors often underestimate the importance of properly reporting all cash transactions, leaving them vulnerable to underreporting their income and unintentionally committing tax evasion.

The failure to accurately report income could result in hefty fines, interest, and penalties on top of potential criminal charges.

It is crucial for contractors to put measures in place to accurately report all cash transactions, including creating a system that tracks all revenue, expenses, and invoices and documenting all transactions properly.

Contractors can educate themselves on the rules, regulations, and procedures regarding cash transactions applicable to their specific location or jurisdiction.

Red Flag #7: Inadequate Insurance

Contractors need to ensure they have the proper level of insurance coverage required by law, such as workers' compensation and general liability.

Without adequate insurance, contractors expose themselves to significant legal and financial risks.

In many states, contractors are required to carry workers’ compensation insurance in case an employee is injured on the job.

The company would need to provide medical care and benefits if this happens, and without proper coverage, the contractor could be held liable for all costs associated with the injury.

It is essential for contractors to stay up-to-date on all prevailing laws surrounding insurance requirements and secure adequate coverage from reputable providers.

Remember, it's incredibly important that you work with a pro-active accountant that can engage with your business position and help identify problems.


Contractors need to be aware of possible red flags that can lead to penalties and IRS audits.

It is essential for contractors to understand the labor laws, sales tax regulations, record-keeping practices, insurance requirements, and other state and federal laws pertaining to their profession.

This can be avoided if the contractor were to hire an accountant to help guide them through the process of preparing their finances and getting ready to file their taxes.

Asnani CPA provides an outsourced accounting model for a variety of industries and we are proactive tax planners, payroll processors, and business tax preparers.

Get in touch with us if you are needing a proactive accountant to help grow your business.

We've found that with fantastic bookkeeping services, pro-active tax reduction planning and business tax return preparation services done by a San Francisco CPA like Asanani CPA, you're going to be in position to avoid IRS Audits & stay focused.