As a business owner, you may be wondering if you can report profits below 8% of gross receipts without triggering an IRS audit. The short answer is maybe, but proceeding with caution is advisable. The IRS uses certain ‘red flags’ to select tax returns for audit, and low profit percentages compared to industry averages are one of them. However, each case is unique, and other factors come into play as well.
Why Do Low Profit Percentages Raise a Red Flag?
The IRS knows that most businesses have certain fixed costs that eat up a minimum percentage of gross receipts. These include costs like rent, utilities, employee wages, insurance, loan interest, etc. If your net profit percentage is significantly lower than industry benchmarks, it raises suspicions that you may be underreporting income or overstating expenses to minimize taxes.
For example, let’s say you operate a retail clothing shop. According to IRS statistics, the average profit margin for this industry is around 32%. However, on your tax return, you show a profit of just 5% of gross receipts. This wide gap would likely trigger an audit, as the IRS tries to determine if there is unreported income or inflated expenses involved.
What Profit Percentage Triggers an Audit?
The IRS does not publish any clear-cut thresholds for profit percentages that automatically trigger audits. However, based on historical data, anything below 8% raises eyebrows. Profit margins between 5-7% have a high likelihood of audit. Less than 5% is almost guaranteed to get audited according to many tax experts.
That said, the IRS looks at more than just the percentage. They also consider industry averages. For example, grocery stores average profits around 2-3%, so 5% would be less suspicious there than for a law firm with typical profits near 30%.
Other Red Flags That Increase Audit Risk
While low profit percentages are a big red flag, the IRS looks at other factors too when selecting returns to audit. Some key ones include:
- Drastic changes in income or expenses from prior years
- Losses reported for multiple consecutive years
- Discrepancies between the return and supplied 1099 or W-2 forms
- Underreporting of income from cash/credit sales
- Unusually large amounts of miscellaneous deductions
The more red flags present, the higher the audit risk becomes. Just the profit percentage alone may not trigger an audit if no other suspicious activities are present.
Ways to Avoid Increased Audit Risk from Low Profits
If your business legitimately has low profit margins for valid reasons, there are steps you can take to avoid heightening audit risk:
- Include detailed explanations and documentation on your return showing why margins are lower than industry averages.
- Hire a certified public accountant (CPA) to review your return.
- File on time – late filers get audited more often.
- Report all income accurately.
- Deduct only valid, documented business expenses.
- Be conservative when classifying expenses as business vs personal.
Essentially, you want to ensure your return is thorough, well-documented, and leaves no room for suspicion. An accountant can help structure your reporting in the most compliant, audit-proof manner.
Strategies to Increase Profit Percentages
If your business is consistently showing low profit margins, it may be time to implement some strategies to improve the situation. Here are some tactics to consider:
1. Increase Sales
One straightforward way to improve margins is to increase sales. With more revenue coming in, your fixed costs remain largely the same, resulting in a higher profit percentage. Some tips for driving more sales include:
- Offer promotions/discounts to incentivize customers
- Advertise through various media – print, digital, radio, etc.
- Leverage social media and email lists to market
- Upsell high-margin add-ons and warranties
- Start a loyalty rewards program
- Extend business hours or offer online sales
2. Lower Costs
Another approach is to work on lowering business expenses. This could include:
- Negotiating better rates from suppliers and vendors
- Finding a cheaper facility/retail space
- Buying used equipment instead of new
- Cutting unnecessary phone, software, and utility expenses
- Offering employees lower cost health plan options
Be careful not to cut expenses so much that it negatively impacts operations, though.
3. Raise Prices
When costs are fixed, another option is raising prices. This grows profit margins with minimal effort. You can:
- Implement small across-the-board price increases
- Adjust specific products/services to higher profit prices
- Bundle items to sell them together at higher combined price
Just be wary of raising prices too much and driving customers away. Incremental increases updated periodically are generally most effective.
4. Offer New Products/Services
Adding new product and service offerings creates new profit streams for your business. Look for opportunities to:
- Sell products related to your core offerings
- Cater to customer needs and fill gaps in your product line
- Partner with other local businesses to package products/services
The key is focusing on complementary offerings that leverage your existing business, processes, and customer base.
Showing Minimal Profits on Tax Return
Reporting very low profit percentages on your tax return is possible, but risky without proper precautions. Keep detailed records, have a qualified tax professional review your return, and take measures to improve margins. With reasonable explanations and documentation, showing profits below 8% does not automatically trigger an audit. But it raises the likelihood, so proceed carefully and emphasize compliance.
Example Scenario
Let’s look at a scenario to illustrate these concepts:
Background
- Jane owns a cupcake bakery in upstate New York
- Annual gross receipts are $550,000
- Net profit was $22,000 (4% of gross)
- Industry average profit margin is 25%
Concerns
- Profit percentage much lower than industry average
- Below the 8% audit benchmark
- High risk of IRS audit
Jane’s Response
- Hires CPA to thoroughly review expenses and tax return
- CPA determines deductions are valid and expenses not overstated
- Jane includes statement explaining:
- Higher ingredient costs from boutique suppliers
- Challenge meeting sales goals due to low foot traffic location
- Higher wage costs to attract skilled staff
The CPA review and detailed explanations help provide assurance to the IRS that the low profit margin accurately reflects the realities of Jane’s business operations and was not manipulated simply to avoid taxes.
Frequently Asked Questions
What profit percentage is considered high risk for audit?
Generally, any profit percentage below 8% of gross receipts is considered high audit risk by the IRS. Under 5% almost guarantees an audit barring strong documentation and explanations.
Does low profit always mean more taxes?
No, low profit does not necessarily mean higher taxes. With lower net income, total tax owed could actually be lower than a business with higher profits. The issue is not higher taxes, but the audit risk from underreported revenues or overstated expenses.
What expenses can be deducted to lower profit percentages?
All ordinary and necessary business expenses are deductible – rent, wages, supplies, utilities, insurance, etc. However, the amounts deducted must be documented and proven reasonable. Unusually high expenses can also raise audit flags if out of proportion for your industry.
Can I show zero profit and not get audited?
Reporting zero profit for multiple years will almost certainly trigger an IRS audit. You may get away with it 1 year if you have large startup costs. But ongoing zero profit percentages are too suspicious for the IRS to ignore and let pass without scrutiny.
What is a safe profit percentage to avoid audit?
There is no completely “safe” percentage that guarantees avoiding an audit. 12-15% is unlikely to trigger scrutiny in most industries. To be cautious, aim for profit margins close to the average for your sector. Significant deviations will require thorough documentation to justify.
Summary
Reporting low profits below 8% on a tax return is possible but risky. Take steps to maximize compliance, documentation, and credibility. While the IRS looks closely at profit percentages, there are other red flags that also increase audit likelihood. Implement strategies to improve margins over time. But with proper precautions, some businesses can legitimately sustain profits below 8% without automatically triggering audits each year.
Conclusion
In summary, businesses can report profit percentages below the 8% benchmark and potentially avoid IRS audit. However, the risk is elevated, so take measures to substantiate figures, align with industry averages, and proactively raise margins. With proper documentation and transparency, low profits do not guarantee audit scrutiny as long as no other red flags exist. Each case depends on its specific circumstances. Proceed cautiously and emphasize thorough, compliant tax reporting to avoid issues.
