Common Tax Traps for Entrepreneurs, Startups & Small Businesses

September 5, 2025September 5, 2025Nick Eusanio, Esq., LL.M. Leave a comment

Federal tax audits or examinations don’t just happen to big corporations. Founders and small businesses are often hit the hardest. This is sometimes because growth outpaces compliance, and sometimes because the rules themselves are complex. Here are some key areas where trouble tends to strike, and what you can do to mitigate risk.

1. Worker Classification: Independent Contractors vs. Employees

Issue: Misclassifying workers can lead to payroll tax assessments, penalties, and even personal liability for owners.

Consider: The IRS applies a multi-factor test focused on control. If you dictate hours, tools, and how the work is done, odds are the worker is an employee.

Action: Use written contracts with contractors. Review relationships annually. Consider preparing and filing IRS Form SS-8 if classification is unclear.

2. Payroll Tax Compliance

Issue: The IRS treats unpaid payroll taxes as one of the most serious violations. Missed deposits, late filings (Form 940 and Form 941), or failure to remit tax withholdings can trigger the Trust Fund Recovery Penalty (TFRP). Under the TFRP, the IRS can collect directly from “responsible persons”—owners, officers, or even bookkeepers.

Consider: Red flags like:

Borrowing from payroll tax withholdings to cover operating expenses.
Repeated late deposits.
Incomplete or inaccurate Forms 940 or Forms 941.

Action: Use an outside payroll provider if you don’t have in-house talent. Always confirm deposits are made, even if a third-party processor is used.

3. Deductibility of Expenses

Issue: The IRS often challenges whether claimed deductions are truly “ordinary and necessary” under IRC § 162. Startups and entrepreneurs are particularly at risk because personal and business expenses sometimes blur together.

Consider:

Startup vs. operating expenses: Generally, pre-opening costs must be capitalized and amortized under IRC § 195. There is a limited first-year immediate deduction of $5,000 in startup costs and another $5,000 in organizational costs. But this deduction is subject to limitations and phase-out.
Meals, travel, and vehicles: Require strict substantiation with logs and receipts. Note applicable limitations like 50% of meals. Identify clear business purpose.
Home office deductions: Often challenged unless the space is used exclusively and regularly for business. Evaluate applicable safe harbor rules and remember deduction recapture rules on sale of your home.

Action: Keep meticulous records. A clean ledger with contemporaneous notes, mileage logs, and calendar entries are key in audit defense.

4. Entity Structure & Elections

Issue: The choice of entity—and whether elections are properly filed—drives tax mechanics and impact, reporting compliance, and controversy.

Consider:

Entity Classification Election (Form 8832): What is the default tax classification of the entity? Is the entity eligible to elect a different tax classification? Options are: association taxable as a corporation, partnership, or entity disregarded from its owner for federal income tax purposes. A late or erroneous election can have significant consequences. These mistakes can impact applicable tax mechanics and rate(s) and reporting obligations. Often, an election mistake leads to other incorrect or missed filings and more tax, interest and penalties.
S Corporation Election (Form 2553): If filed late or incorrectly, the IRS treats the company as a C corporation. This creates unintended double taxation. As above, impacts can also include other incorrect or missed filings, more tax, interest and penalties.
Reasonable Compensation: S Corp shareholders who underpay themselves and take most income as “distributions” risk IRS reclassification. This reclassification often triggers more payroll tax liabilities.
Conversions and Reorganizations: Changing from an LLC with partnership or disregarded entity tax classification to a corporation (or vice versa) can trigger unanticipated tax consequences. As before, this often leads to more tax, interest, and penalties if not carefully planned.

Action: Confirm your entity elections are on time, appropriate, and as intended. Keep written records of salary determinations and supporting research. Consult tax counsel before making any structural changes or elections.

5. Qualified Business Income (QBI) Deduction (IRC § 199A) Complexities

Issue: The 20% deduction can be huge—but the rules are highly technical. The IRS closely examines whether a business is a “specified service trade or business” (SSTB), how wages are calculated, and whether property is properly classified.

Consider:

Is your business type listed as a SSTB?
How are wages and property allocated?
Do income thresholds limit your deduction?

Action: Model the deduction annually to confirm eligibility, and document how wages and property are allocated. Careful planning around compensation, entity choice, and property ownership can preserve or improve the benefit.

6. Sale, Exit & Mixed-Character Transactions

Issue: When it’s time to sell, how you structure the deal often impacts whether proceeds are taxed as ordinary income or capital gain.

Consider: Impact to character (ordinary or capital gain) of gain, tax rate, and timing from:

Stock / equity sale (legal) treated the same for tax purposes,
Asset sale (legal) treated the same for tax purposes OR Stock / equity sale (legal) treated as an asset sale for tax purposes (available elections / requirements)
- Allocation of purchase price to asset classifications (e.g., accounts receivable, inventory, goodwill, etc.)
Installment sale treatment
Foreign Investment in Real Property Tax Act (FIRPTA) for foreign investors selling an interest real property or a real-property rich entity.

Action: Get tax advice before signing the letter of intent. Once the framework structure is agreed upon, the tax impact of the final deal is often limited unless flexibility was built in.

7. Recordkeeping & Documentation – IRS Audit

Issue: The IRS doesn’t always take your books at face value. If records are thin, the IRS can use indirect methods to recreate your P&L. This can include bank deposit analysis, percentage markup analysis, or lifestyle audits (looking at cash and credit card expenditures and assets).

Consider / Action: Keep separate business and personal accounts and reconcile monthly. Save receipts and invoices. Prepare clear schedules for deductions. Save other relevant supporting documentation from third parties.

8. Penalties & Interest

Issue: The tax bill is only part of the pain. Late filing, late payment, and accuracy-related penalties can quickly snowball.

Consider:

IRC § 6651 penalties for failure to file/pay.
IRC § 6662 accuracy-related penalties for negligence or substantial understatement.
Other IRC provisions imposing penalties for failure to file related to certain informational returns.

Action: Keep a tax compliance calendar with entries and recurring reminders for all tax filing and payment due dates and amounts. Task a responsible employee (or a third-party consultant) with monitoring and managing all tax obligations to ensure timely reporting and payment.

Final Word

For entrepreneurs and small businesses, tax controversies often arise not from intent but from oversight, rapid growth, or technical missteps. Minding entity classification elections and payroll tax obligations, documenting deductions, and involving tax counsel early in transaction planning, can help small businesses avoid many of the most common IRS challenges.

Often a short consultation with a tax attorney can save you from years of penalties, interest, and costly disputes. If you’re facing an IRS notice of audit or examination, notice of proposed adjustment, or IRS collection action, don’t delay. Now is the time to contact tax counsel with experience in tax controversy matters. Prompt action with a tax attorney in your corner can improve results. Potential benefits can include avoiding or releasing tax liens and levies, reducing tax, interest and penalties, or settling tax debts for less than the amount owed.

College Tax Credits: Parent & Student Primer

November 1, 2016November 1, 2016Nick Eusanio, Esq., LL.M. Leave a comment

Parents and students, by now, you’re certainly in the full chaos of the academic year – spending that hard-earned money to help your child get the education necessary to pursue a great future career. Before too long, you’ll also be working through the challenges of gathering information and documents for tax return filing season – and by then you’ll be keenly aware of just how much you’re spending to obtain that all-important college degree. Likewise around tax filing time, you will probably be searching for and considering what summer jobs, internships, or other opportunities may be available to help pay for or defray some of the cost of college now, or at least help bolster your child’s prospects for future employment to repay college debt.

While the cost of college education can definitely be burdensome, and tax season is a drag for most, there are some federal tax provisions that can help relieve some of that burden and make you excited (ok, maybe just less anxious!) about tax season. That’s why this article is dedicated to summarizing the most useful information regarding available college tax credits for parents and students.

Biz&TaxHax Tip: Biz&TaxHax hopes this article proves useful in your quest to save money on, and make the most of, your education. In that spirit, we also want to be sure to introduce you to our friends and colleagues at Nunan Vogel Rowe (NVR), who are experts in career coaching, especially college-to-career coaching. Biz&TaxHax likes to team with like-minded professionals to bring you the most relevant, useful information to help you plan and find solutions to your challenges. NVR is certainly a golden resource for students and their parents navigate the key planning and decision-making that makes all the difference in future career prospects. To do this, NVR’s leaders draw on their experiences as big-company executives with strong backgrounds in identifying, recruiting, evaluating, and developing the best talent in industry. Simply put, they’ve been there and done that one-thousand times over, and can help you tremendously.

Available College Tax Credits & General Requirements

There are two college tax credits available, these are the:

American Opportunity Tax Credit; and

Lifetime Learning Credit.

Each of these education tax credits has its own specific requirements, but both share the following general requirements:

You, your dependent or a third party paid qualified education expenses during the tax year for,

An eligible student who was enrolled at an eligible educational institution, and

You, your spouse, or a dependent listed on your tax return is the eligible student.

Generally, these education tax credits exist for eligible students attending an eligible college, university, or vocational school, and the amount of credit allowed is limited based on the amount of eligible expenses and taxpayer’s income level. Although a particular taxpayer will often qualify for both the American Opportunity Tax Credit and the Lifetime Learning Credit, a taxpayer may only claim one of these credits for a given tax year.

American Opportunity Tax Credit (AOTC)

The American Opportunity Tax Credit is available to any taxpayer who pays qualified expenses for an eligible student. A taxpayer, the taxpayer’s spouse, or the taxpayer’s dependents can all be eligible students, and the American Opportunity Tax Credit allows a credit for each eligible student. A substantial number of taxpayers who are eligible for the American Opportunity Tax Credit will qualify for the $2,500 maximum credit amount, which is a per year, per student maximum. But, it is important to keep in mind that a taxpayer can only claim this credit for four tax years for each eligible student, and only for eligible students who have not completed their first four years of college education prior to 2016.

Biz&TaxHax Tips: In considering whether you may be able to claim the American Opportunity Tax Credit, the following are important points to keep in mind, but you should always contact an experienced tax attorney or tax consultant to fully discuss your facts and circumstances and help make this determination:

Qualified Education Expenses: Tuition, fees, and certain other expenses that are required for enrollment or attendance at an eligible educational institution constitute qualified education expenses. Common other expenses that qualify are expenses for books, supplies, and equipment that are needed for a course of study. Some types of expenses that do not qualify are: insurance, medical expenses (including student health fees), room and board, transportation, or similar personal, living, or family expenses.

Credit Amount: To claim the full $2,500 tax credit, your qualified expenses for an eligible student must be $4,000 or more (and you must not be limited by income-level).

40% Refundable: The American Opportunity Tax Credit is 40% refundable, meaning that even if you owe no federal income tax, you may be able to claim up to $1,000 in refund for each eligible student (again, subject to income-level limits and the amount spent on qualified educational expenses).

Income Limits: For 2016, single taxpayers with a modified adjusted gross income (MAGI) of $80,000 or less, and married taxpayers filing jointly with a MAGI of $160,000 or less, may claim the full $2,500 credit (again, assuming enough qualified educational expenses to support it). This credit phases out as the various types of taxpayers’ incomes rise above these levels, and the credit vanishes when MAGI is $90,000 (single, head of household, some widows and widowers) or $180,000 (married filing jointly).

Lifetime Learning Credit

Undergraduate and graduate students alike are eligible for the Lifetime Learning Credit, which provides a tax benefit of up to $2,000 per tax return (rather than per student, like the AOTC). Another important distinction between the Lifetime Learning Credit and the AOTC is that the Lifetime Learning Credit is not refundable, meaning that a taxpayer with no tax liability will not receive a refund for the amount of this tax credit that he or she is eligible to claim. But, one positive difference with the Lifetime Learning Credit is that a student need not be a half-time student at the eligible educational institution to qualify; rather, the student can be pursuing a course of study part-time to maintain or improve job skills or as part of a degree program at an eligible educational institution.

Biz&TaxHax Tips: If you are evaluating whether you may qualify to claim the Lifetime Learning Credit, these are some helpful tips to discuss with a tax lawyer or tax consultant, who can help you analyze eligibility and claim the credit:

Qualified Education Expenses: Qualified education expenses include tuition and fees required for enrollment or attendance at the eligible educational institution, and other fees required for coursework there. Any additional expenses do not qualify.

Credit Amount: The maximum amount of the credit is $2,000, and the credit is calculated as a percentage (20%) of eligible expenses for all eligible students listed on the return. So, to claim the maximum credit, a taxpayer must have paid at least $10,000 in qualified expenses for the year.

Income Limits: Single taxpayers with MAGI of $55,000 or less, and married couples filing jointly having a MAGI of $111,000 or less, may claim the full Lifetime Learning Credit for 2016. The credit diminishes as income levels rise, and it vanishes at $65,000 (single, head of household, some widows and widowers) and $131,000 (joint filers) of MAGI.

Other Education-Related Tax Benefits

Even if you do not qualify for one of the college tax credits, you may be able to benefit from one of the following other education-related tax benefits:

Grants for Scholarship and Fellowship, which are usually tax-free if they are used to pay for tuition, required fees, books, and other course materials, but are taxable if applied to room, board, research, travel, or other expenses.
Deduction for Tuition and Fees
Deduction for Student Loan Interest (up to $2,500/year, depending on amount of interest paid and income level).
College Savings Bonds, the interest on which is generally tax-free depending on the taxpayer’s income level, the time of purchase, and taxpayer’s age at the time of purchase.
QTPs (Qualified Tuition Programs) such as a 529 Plan.

As always, for parents and students considering eligibility for college tax credits like the American Opportunity Tax Credit and Lifetime Learning Credit, or other education-related tax benefits, as well as related planning, reporting and payment obligations, it is best to consult an experienced tax attorney or tax consultant. A tax lawyer or tax consultant can fully evaluate your facts and circumstances along with applicable law and guidance to develop the most effective, efficient, and proper solution to your tax compliance and planning needs.