Thanks to a variety of industry quirks, construction companies are especially vulnerable to IRS audits. But by avoiding some common audit triggers, you can keep Uncle Sam at bay.
Here are four ways to do minimize your risk of an IRS audit.
1. Consider the Accrual Method
It’s no secret that many contractors prefer cash accounting to accrual accounting, which can be more complex and sometimes require you to pay taxes on income you haven’t yet received. The IRS, on the other hand, isn’t a big fan of cash accounting because it can delay tax payments.
Generally, the IRS allows contractors with less than $10 million in annual sales to use the cash method. But, the accrual method is required for C corporations with more than $5 million in annual sales and for contractors who spend generally 10% to 15% of their gross income on substantial purchases of materials, such as inventory or lumber — even if annual sales are less than the otherwise applicable $5 million or $10 million threshold.
If you’re audited and you’ve been using the cash method when you should have been using the accrual method, you may be forced to postpone deductions and pay penalties. Even if you aren’t required to use the accrual method, be aware that using the cash method may invite IRS scrutiny.
2. Mind Your Independent Contractors
Independent contractors are a big part of the construction industry. But if your business uses them, proceed with caution. The IRS has long believed that a significant percentage of employers misclassify employees as independent contractors.
In fact, the agency began a three-year crackdown in 2010 on such employers in an effort to recoup any taxes those organizations should have paid. To avoid becoming one of the crackdown’s targets, make sure that your workers meet the criteria for independent contractors and that you issue 1099 forms to them.
3. Keep Long-term Contracts Legit
As you may know, contracts that span over two calendar years are considered long-term. What you may not know is that the IRS watches these carefully to make sure contractors pay their taxes on the monies involved in a timely manner.
Many long-term contracts are subject to the percentage-of-completion method, which requires contractors to pay taxes each year on the portion of the contracts that were finished in that year. Some smaller contractors are allowed to use the completed-contract method, though, which lets them put off paying taxes until projects are done.
If you’re using the completed-contract method, keep in mind that the IRS may look into such contracts to make sure you’re not unnecessarily dragging out the terms. A couple of potential audit triggers: 1) a delay in completion of a contract that’s almost done to the next tax year and 2) a contract that contains separate projects that could be treated as separate contracts, such as identical apartment units.
Check out our blog post, 3 Types of Construction Contracts: Their Pros and Cons for Owners and Contractors, for a refresher on contracts.
4. Consider an “S” Election
In certain cases, operating an S corporation can help shield you from an audit more effectively than a single-member limited liability company (LLC) or a sole proprietorship.
Contractors who own LLCs are six times more likely to be audited than those with S corporations, a recent IRS study shows. Although you shouldn’t change your business structure just to minimize IRS scrutiny, it’s a factor worth considering when reviewing how your construction company is set up.
There's No Magic Bullet
The IRS audited 11% more returns in 2010 than in 2009, according to agency statistics. And with a growing federal deficit to plug, the government has hinted that taxpayers should expect more audit crackdowns going forward. Even if you have nothing to hide, an audit can be an expensive process, draining valuable time and resources from your business.
There’s no magic formula for keeping the IRS away from your door, but taking the right precautions should at least reduce your risk of getting stuck with an audit. And that increases the likelihood that you’ll have more time to focus on what’s important — running a successful construction company.
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