IRS Red Flags: Audit Triggers for Construction Contractors

Are you putting yourself at risk for an IRS audit? What kind of things do the IRS target for contractors? We’re breaking it down on the podcast this week.

Topics we cover in this episode include:

  • Accounting method rules based on the type of contractor you are
  • Contract-related services and advanced payments
  • Things on the expense side that can trigger an audit
  • Unreasonable compensation
  • Charitable contributions
  • Misclassification of workers
  • Unusual transactions
  • Drastic changes in expense classification from one year to the next


Join the conversation on our LinkedIn page:

Wade Carpenter, CPA, CGMA |
Stephen Brown, Bonding Expert |


[00:00:06] Wade Carpenter: Are you putting yourself at risk for an IRS audit? What kind of things do the IRS target for contractors? Come on in, let’s talk about it.

This is the Contractor Success Forum. I’m Wade Carpenter with the Carpenter Company CPAs. With me, as always, my co host Stephen Brown with McDaniel Whitley Bonding and Insurance.

Stephen, what a topic today. What do you think?

[00:00:25] Stephen Brown: It is, nobody likes to get audited and, construction company, it’s like a moving target. There’s so much to the accounting end of it. I think it’s great you’re going to tell our listeners a little bit about all the moving parts of a construction company and the audit risk that it might face.

[00:00:43] Wade Carpenter: Yeah, I mean, I don’t know if we’re going to hit all the moving parts of the construction company today. But one thing a lot of people don’t realize is the IRS actually publishes a Construction Industry Audit Technique Guide that is actually open to the public.

And it’s actually publication 5522. The last version of it is dated April 19th at 21 as of the day we’re recording this. And they do put this out every year, but they do regularly update it. It’s something that people ask me all the time. There’s a lot of contractors that don’t realize that they’re doing some things that could be triggering an audit or at least triggering things that might make them look at you a little harder.

[00:01:22] Stephen Brown: Of course.

[00:01:23] Wade Carpenter: So I thought we’d just hit some of the high notes today and we won’t necessarily go into all the details of it. Some of the things that we see all the time, and even when we take one over, we see, some errors or, people just don’t know the industry. So there are definitely some quirks to it.

Accounting method rules based on the type of contractor you are

[00:01:41] Wade Carpenter: And the first I want to talk about was the accounting methods. There’s a lot of rules and regulations about accounting methods, and we can talk about that. But in particular, there are some rules that have to do with five main groups with construction contractors. And then there’s some definite subgroups under there. I’m going to run through them real quick.

There’s what they call a large contractors. Which, those used to be over 10 million and after 2017 jumped it up to 25 million and they’ve indexed that for inflation. Now it’s right around 30 million before they consider you a large contractor and requiring percentage completion.

Small contractors is anything below that. There’s home builders and developers. There’s land developers, and then there’s spec homebuilders.

And all five of those classifications have very different rules about how to account for things.

[00:02:36] Stephen Brown: Okay. Just right off the cuff. What is the reasoning for having these different rulings for the different groups?

[00:02:44] Wade Carpenter: One, for the large contractors, they want to make sure that you’re doing a representative.

[00:02:49] Stephen Brown: That sounds a lot more polite than cheating.

[00:02:51] Wade Carpenter: Right. Basically, they want to ensure that you’re properly reporting your income and expenses. And when you get above a certain amount, they’re going to force you on the percentage of completion rules.

[00:03:03] Stephen Brown: Okay.

[00:03:04] Wade Carpenter: There are ways to cheat with that as well. I should say I like your terminology.

[00:03:10] Stephen Brown: That was your terminology. Better represent yourself in an equitable way that you can sleep at night, I don’t know.

[00:03:17] Wade Carpenter: There are some definite differences between, say, even a large contractor on percentage of completion, that method that Generally Accepted Accounting Principles say we’re supposed to follow, and what the tax rules talk about. So we can talk about that, but there are also some exceptions for smaller contractors below that.

And for many years, there was a 5 million rule that had to do with accrual accounting. And then there was a 10 million rule. And a lot of people, especially in construction, there’s CPAs all over the country that did not know there was different rules for contractors that would put people on things like accrual basis when they didn’t need to be on accrual basis.

And for a smaller contractor, we all know cash is king. And if you had to pick up income for receivables that you don’t have in the bank yet, or retainage, then, that can kill a otherwise, good contractor.

Do you have any specific questions about that?

[00:04:18] Stephen Brown: No. What triggers a possible audit situation for these different construction classes?

[00:04:25] Wade Carpenter: There’s several things that we’ll talk about.

But, one of the improper use of these accounting methods, and if we’re misapplying the rules, some of the other things that we could get into, there are rules around the way you treat retainage.

There are rules about stored materials. If somebody’s on percentage of completion for Generally Accepted Accounting Principles, your financial statement, it says you don’t have to recognize the income on that stored materials until you actually install it.

Tax rules actually say you have to actually pick that income up, and they want their taxes based on that.

[00:05:01] Stephen Brown: Okay.

[00:05:01] Wade Carpenter: Another example of that is if you have losses on a percentage of completion basis for financial statement purposes, you’re supposed to recognize that immediately as soon as you know it’s going to happen. For tax purposes, they’re not going to allow that loss until you actually recognize it.

So there are several reasons that, the way you may account for it for book purposes and tax purposes could be different. Even if you have an audited financial statement, that audited financial statement may not actually translate to a tax return.

[00:05:33] Stephen Brown: Okay.

[00:05:33] Wade Carpenter: But again, the rules and the things that trigger these have to do with things like revenue recognition. Are we recognizing revenue properly? You brought up recently the changes in some of the rules for GAAP purposes.

And, those tax rules really haven’t changed. Those are more rules that would affect things like the banks and bonding company, the way they look at things.

Contract-related services and advanced payments

[00:05:59] Wade Carpenter: There are things they call contract related services, things that are really peripheral to the contract, and how you have to treat them.

There are definite rules about, you know, you take a deposit up front or mobilization money. Do you have to pick that up ? And some of the rules, you have to be very careful about applying that because just because you got a deposit up front and you haven’t started work doesn’t mean you may not have to pick that up. So those advanced payments can come back to bite you.

[00:06:28] Stephen Brown: Okay.

Things on the expense side that can trigger an audit

[00:06:28] Wade Carpenter: Some of the biggest things, though, I think that most people don’t really think about are on the expense side. And, just going to talk about a few of these.

Just thinking about more things that would trigger an IRS audit. The way people pay, like out of town living, you know, per diem, and the lodging and those kind of things. The IRS actually puts out tables that specifies what is allowed for paying them, or at least a standard. And somebody can always turn in actual receipts for that, but–

[00:07:01] Stephen Brown: If it’s more, of course.

[00:07:03] Wade Carpenter: If it’s more. They don’t actually have to pay that standard, and the rules used to say that if an employee, while they technically still do, say that if an employee doesn’t get reimbursed up to the IRS standard, they can claim it on their personal income tax.

But the problem is, after 2017, that was a miscellaneous itemized deduction. If you’re an independent contractor, that’s one thing, and you can probably put it on Schedule C. But that is one thing that the IRS sometimes will definitely look at the per diem rates and the expenses out of town living, that kind of stuff.

So that’s one of the flags I would point out.

The personal use of things like business assets and in particular vehicles. And contractors use their trucks all the time and they know that, but when you go putting your Mercedes or, something like that, that you’re not going to drive to the job–

[00:07:56] Stephen Brown: Well, it’s, it’s your wife’s Mercedes.

[00:07:58] Wade Carpenter: Exactly, or your kid’s car or something like that.

Claiming that, especially if they catch it and it doesn’t seem to be a business vehicle, that can also be a flag.

[00:08:09] Stephen Brown: What about your boat? Some people call them yachts, sometimes you just got to have a good boat to get your work done.

[00:08:15] Wade Carpenter: If you’re a marine type contractor, maybe. But those with planes and some of those things, definitely can trigger some questions.

[00:08:23] Stephen Brown: I can tell you from my point of view, from the bonding standpoint, it seems like in the 60s, 70s, early 80s, contractors– and maybe not just contractors, all businesses, had a corporate retreat, which was their lake house.

And, there’s always a time where there’s just certain hobbies that you have that you want to support through your business. And most famously among contractors are the purchase and use of helicopters and airplanes. That’s an inevitable stage that a lot of our customers go through.

[00:08:57] Wade Carpenter: Yeah, I’ve seen the airplane thing, too, a lot, and it also can generate some questions as well. If the contractor is flying all over the country, that’s one thing. But if it’s just their little hobby on the weekends, you got to watch that. I’ve seen some, like some of mine will, we got to fly down here to the Atlanta Raceway and get in their–

[00:09:18] Stephen Brown: Yeah, but you’re entertaining people.

[00:09:20] Wade Carpenter: Absolutely.

[00:09:21] Stephen Brown: And you never know when Dale Earnhardt Jr. might want to build something.

[00:09:26] Wade Carpenter: As far as entertainment too, after the 2017 act, most entertainment is not deductible at all. And when you get into the classification where it could be meals or entertainment, you really–

[00:09:38] Stephen Brown: Put it under meals is what you’re saying. Okay.

[00:09:40] Wade Carpenter: I didn’t say that.

[00:09:41] Stephen Brown: I’m sorry. That’s it. That’s all I was, that’s not what I was hearing. I’m sorry.

[00:09:45] Wade Carpenter: But like I said, meals are another thing. For a few years, they made them 100 percent deductible because of COVID, but all that’s gone now.

But there are rules for when you can claim meals for your employees, versus, I just want to go have lunch on the company. And there are rules about documenting it, saying who you went with and you don’t have to be real detailed, but you at least have to have some kind of recap of who you took and the fact that you talked about business.

Unreasonable compensation

[00:10:17] Wade Carpenter: Some of the other things, you know, the unreasonable compensation. Especially for S Corporation owners, making sure that you’re taking a proper salary in your business. That is something they started attacking again, and it’s one of those things that is hit and miss.

Still believe the IRS is still coming out of COVID, and they were supposed to be hiring 87, 000 IRS agents, and they don’t have them all trained up. But whether they do or not, there’s been an increase in these, what they call desk audits, where they will pick a line item and send you a letter and say you have to send in proof of that. And they can do that a lot more efficiently.

But that’s some of the things I’m talking about.

[00:11:02] Stephen Brown: Okay.

Charitable contributions

[00:11:02] Wade Carpenter: And as far as those kind of desk audits, one of the things they have been looking at is charitable contributions. That’s what I see a lot of times. And you do need to be able to have some backup for whether they were truly charitable contributions or whether it was just for your son’s baseball team decided to travel around the country. Was that really a charitable deduction?

[00:11:24] Stephen Brown: It’s un-American that you can’t deduct that. Seriously. No I’m kidding you Wade. Go ahead.

[00:11:29] Wade Carpenter: It’s okay.

[00:11:30] Stephen Brown: But it does seem un-American. Go ahead.

[00:11:32] Wade Carpenter: We did talk about the, like I said, unreasonably low compensation. They don’t really get a lot into the unreasonably high compensation for most companies, but–

[00:11:42] Stephen Brown: Why would they care if it was unreasonably low if it was your company?

[00:11:47] Wade Carpenter: So for an S corporation, that’s one of the main reasons that people like to do S corporations is because–

[00:11:53] Stephen Brown: They have to take the money out. Yeah.

[00:11:55] Wade Carpenter: You can take the money out, but you’re taking it out without paying self employment taxes on it. And the IRS needs to make sure that you’re paying a proper amount of self employment taxes.

The example I always give is you make 100, 000 in profit and you take zero in payroll, you’re asking the IRS to come hit you for , that other 15 percent of self employment taxes. If you take some kind of reasonable salary, you can justify it, You’re usually fine.

For several contractors, we do what’s called reasonable compensation studies to see what they’re actually doing and in their business, and it’s provides support for, if you ever did get audited, and I’ve had a couple of people audited for this, and we usually did it for the IRS purposes, but it’s actually saved us on a couple of Department of Labor audits.

[00:12:44] Stephen Brown: Okay.

Misclassification of workers

[00:12:45] Wade Carpenter: One of the other things that we talk about all the time for as long as I’ve been in the business working with contractors, misclassification of workers. Trying to call everybody 1099 when they really should be an employee.

And it’s very rampant in the industry. We understand that, everybody else, most of the competition is probably using, 1099 labor. And again, I’m not trying to preach it to anybody on this podcast, but if they’re truly an employee, if you tell them what to do and when to do it, that’s my oversimplification of the rules. But–

[00:13:17] Stephen Brown: Are there still those five IRS employee definition guidelines? There

[00:13:24] Wade Carpenter: There’s been a–

[00:13:25] Stephen Brown: May be more, but I just remember that.

[00:13:27] Wade Carpenter: There’s actually a 20 factor test they’ve gone through in that five factor test. And there’s no hard and fast rules. And it’s facts and circumstances. There are definitely things that you can do to make sure that they, if you’re having a contract and, again, I don’t want to go too deep into that. But if you’re documenting and they send you an invoice versus, hey, they turn in hours and we pay them just like we pay employees, then you may be asking for IRS to come talk to you.

Another thing that I see, not just personal income taxes, contractors get behind on their personal income taxes, but failure to pay the payroll taxes properly. We see that all the time and it happens in all businesses, but cash flow in construction is always tough. And , you got to pay your people, you got to pay your suppliers or they won’t get you the materials. You, you gotta keep going.

And if the IRS is not right in front of your face, sometimes they’re the ones that get put to the back burner and that can snowball on you.

[00:14:26] Stephen Brown: Absolutely.

[00:14:28] Wade Carpenter: I think those were some of the main ones, but some of the other ones I’m just going to throw out really quickly.

They have categories for are these deductions excessive? As a percentage usually, or whatever, or dues and subscriptions and, misclassifying that. If something looks way out of whack, they may look at that dues and subscription like, is that really your country club? Country club dues are not deductible whatsoever. Income–

[00:14:52] Stephen Brown: You’re not telling me you can’t deduct your hunting club, are you? Cause that’s, I don’t want to hear that.

[00:14:58] Wade Carpenter: Well, there’s nothing specifically says hunting club. There’s a definite rule that says country club,

[00:15:04] Stephen Brown: Okay.

[00:15:05] Wade Carpenter: But —

[00:15:05] Stephen Brown: Yeah. No. This is nothing like country club. It’s, it’s nice. Okay.

Unusual transactions

[00:15:10] Wade Carpenter: Unusual transactions. If you’re a contractor that is really like an LLC reported on Schedule C, if you’re constantly showing losses and there is such a thing as a hobby loss, I see that all the time, claiming more mileage than they could possibly do. And contractors can drive quite a bit,

Drastic changes in expense classification from one year to the next

[00:15:27] Wade Carpenter: They will look at your expense classification from one year to another, and there’s a huge, drastic change in the percentages that also, those are the things that can. flag an audit, trigger some questions. Do you have contracts in place? Do you have those kinds of things?

All these things are just things that I see all the time. So I just wanted to throw that out on this podcast. I don’t like doing IRS audits. And that’s not my goal. I don’t want people listening to this to call me because they got an IRS audit. It’s more of, let’s protect you before you get to that point.

And, make sure that you can document it and sleep well at night, knowing that you’ve got good books in place and you can back up the things that you put on your tax return.

[00:16:12] Stephen Brown: That’s right. And honestly, I’ve seen numerous contractors go under, bankruptcy, because they didn’t want to pay their taxes. It’s a fact of life. I know in a Profit First system, you’re setting the proper tax. out of every check that comes in the door. Get it set up right and use everything you can legally use to minimize your tax burden, of course.

But like you said, you want to be able to sleep at night and. Of course, I was just kidding you about all the deductions and everything.

[00:16:44] Wade Carpenter: know that. I know that.

Again I believe the best approach is knowing the law. And I talk about all the time planning before the end of the year, so you’re not scrambling to make these moves.

[00:16:56] Stephen Brown: Okay. Again, I would, of course I would say that’s a good point. Wait, don’t call me if you’re being audited by the IRS. I’m not your problem solver. I want to be your proactive guy that can go in there and help you set things up the right way and interpret the laws and rules and regulations for accounting and paying your taxes.

And again, I’ll say for the umpteenth time that embarrasses you every time, you get what you pay for. Construction is a different accounting world and you need a construction oriented accountant like Wade to help you do things the right way. So don’t be afraid to contact the right person, find the right person and just get it done right and don’t worry about it.

[00:17:35] Wade Carpenter: Absolutely. If anybody listening has had some other audit flags or questions, put ’em in the comments on YouTube or, a blog post or the social media, we’d love to hear from you. If you’ve got other thoughts or topics you’d like us to discuss, we’d love to hear it.

And wanted to thank you all for listening to the Contractor Success Forum. Check out the show or the Carpenter CPA’s YouTube channel for more information. We would appreciate it if you consider subscribing. Follow us every week as we post a new episode and we will look forward to seeing you on the next show.