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9 Contractor Accounting Mistakes that Lead to Fraud & Audits

Devin Whyte

9 Mistakes That Lead to IRS Audits for Contractors?

How do contractors end up getting audited by the IRS?

What leads to an IRS audit for Contractors?

Why do general contractors & construction companies get audited?

How can contractors prevent an IRS audit

Here at Whyte CPA Tax & Accounting, we specialize as a construction accountant and bookkeeper for contractors.

This article is not legal tax advice, and you should talk to a tax professional like ourselves for specific advice.

Most contractors miss out on scaling their business and reducing their taxes, because their accountants are reactive, don't provide leadership, or they're too busy to provide pro-active guidance.

Here at Whyte CPA Tax & Accounting, we don't just prepare your taxes and handle your bookkeeping services, we'll provide the analysis, guidance and leadership to your construction company to scale, grow & avoid problems with the IRS.

Our goal is to help you reduce taxes, avoid spending resources on admin, and empower you to focus on your business.

We do that by serving as your outsourced accountants.

for a simple, flat monthly retainer, we will handle all the bookkeeping, payroll and accounting, while helping you do everything to reduce your taxes and grow a more scalable business.

Great tax planning for construction companies includes planning for new equipment, handling cash flow problems, utilizing multi-company strategies, and helping develop long term wealth and tax plans.

We're on a mission to pursue your best interests, and that's why we don't work with hundreds of clients, but we exclusively work with a small group of businesses.

9 Accounting Mistakes Contractors Make:

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

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

Accounting Mistake #1 - Misclassification of workers as 1099 vs. W2

Most business owners hate being on the hook for employees rather than contractors.

You have a great deal of flexibility, options, and independence when you operate with 1099 contractors, vs. a W-2 Employee.

This means that contractors are always leaning towards making people sub contractors, but then breaking the rules.

You can read what the IRS says about 1099 vs. W-2 here.

Summary of the IRS advice on classifying as a 1099:

The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.

Contractors may inadvertently misclassify employees as independent contractors, which can lead to underpayment of payroll taxes, workers' compensation premiums, and employee benefits.

If you make mistakes in how you manage your jobs & trade partners or "employees", you'll end up paying a great deal in fines and penalties when the labor is reclassified.

Be careful to read great advice about the 1099 sub contractor vs. W-2 Employee.

Misclassification can result in penalties and fines from tax authorities and labor departments.

Accounting Mistake #2 - Unintentional errors in reporting

Look, too many contractors just make common sense mistakes when it comes to reporting revenue, classifying deductions, or accounting.

The second most common thing that leads to IRS audits for construction companies is errors in reporting.

Inaccurate financial reporting due to unintentional errors or lack of understanding of tax regulations can lead to underreporting of income or overstatement of expenses, which may be considered tax fraud.

Accounting Mistake #3 - Ignorance of sales tax laws

Sales tax isn't often a huge deal in the construction industry, but when a mistake is made, the tax authorities are unrelenting.

Generally speaking, you'll need to pay sales tax when you purchase materials, and some contractors get in trouble pushing this law.

Contractors may not be aware of the specific sales tax laws in their jurisdiction, leading to under-collection or non-remittance of sales tax, exposing them to penalties and fines.

Here are some things to understand about Sales Tax & the Construction Industry:

Sales Tax on Construction Materials: In most states, construction contractors must pay sales tax when they purchase materials used in construction. This means materials and supplies you purchase are taxable at the time of purchase, but you won't have to pay sales or use tax upon the sale of the finished construction.

Reseller Status: Some states treat construction contractors as resellers. These contractors don't have to pay sales tax when purchasing materials if they're for resale to an end user. The states that provide this treatment vary depending on the type of contract used (lump-sum or itemized).

Exemptions: Certain states provide exemptions to the general rule of contractors paying sales tax on purchases. These exemptions may depend on the type of contracts negotiated and who the clients are (e.g., non-profit or governmental agencies).

Contract Types: The type of contract (lump-sum or time and material) can affect when sales taxes on materials and supplies must be paid.

Subcontractors and Sales Tax: Subcontractors are typically treated like end consumers and have to pay sales and use taxes when purchasing supplies and materials. However, certain states provide exemptions for subcontractors.

Customer's Sales Tax Exemption: In some cases, a customer's sales tax exemption, such as those held by nonprofit organizations, can flow through to a contractor, potentially leading to significant tax savings. This is subject to specific rules and close scrutiny by tax assessors.

Sales Tax on Materials for Resale: In some states, construction contractors can buy materials and supplies tax-free if the property is designated for resale, with sales taxes collected upon resale. In states that don't allow this, contractors may need to apply for a credit for sales taxes paid against the tax incurred when the material is resold.

Interstate Sales Tax: Some states provide exemptions for materials and supplies to be used for out-of-state construction jobs. Contractors should familiarize themselves with these provisions to avoid unexpected use tax in their home state.

Changing Tax Rates: If the tax rate changes after purchase but before delivery, the impact on the contract price will depend on the state. It's advisable to check with the state tax assessor to determine if old tax rates apply to current periods for uncompleted contracts.

The bottom line is that sales tax complexities for construction contractors can vary significantly by state and by contract type, and it's essential to understand these complexities to manage tax liabilities effectively.

Accounting Mistake #4 - Incomplete or inaccurate record-keeping

Sloppy & incomplete bookkeeping or record keeping can lead to mistakes, problems and audit red-flags.

Contractors must keep up with their bookkeeping & accounting, or it will eventually cause trouble in your life.

Poor record-keeping practices can result in incomplete or inaccurate financial records, making it difficult to substantiate expenses, deductions, or income during an audit.

Accounting Mistake #5 - Performing Un-permitted work

Red tape and bureaucracy is the bane of every contractor.

Cities and municipalities aren't making this any easier to perform work.

While the IRS is not concerned about permitting etc, we know that when your'e getting stuck in the quagmire of red tape and inspections, your team gets distracted, your accounts payable becomes a mess, and you end up struggling.

Carefully complying by bureaucracy will actually help you avoid IRS problems because it allows your team to focus & keep life simple.

Contractors may unknowingly perform work without the required permits, licenses, or inspections, which can result in fines, penalties, and potential legal issues.

Accounting Mistake #6 - Not adhering to prevailing wage laws

When you start doing public jobs, you'll need to carefully abide by the red tape and bureaucracy concerning "prevailing wages".

Federal and state construction projects are often subject to certified payroll rules, which are dictated by the Davis-Bacon Act of 1931.

Reporting of wages, overtime, benefits and fringe benefits are just a few of what the government wants to know about.

You'll need to obey the rules concerning public works jobs, certified payroll and prevailing wages.

You'll need to follow your city and state rules concerning the Davis Bacon Act, and avoid problems.

While the IRS is not the authority enforcing these rules, once audits begin from one authority, the others are often brought in as the auditor finds items of concern.

Contractors may unintentionally violate prevailing wage laws by not paying the mandated wages to employees working on government-funded projects.

Accounting Mistake #7 - Inadequate insurance coverage

You need to be insured, you should be bonded, and your vehicles must have the proper commercial insurance protections.

Insurance is difficult for contractors, as the premiums start piling up left and right.

Whether it's surety bonding, performance bonding, commercial vehicle insurance, liability insurance or simple BOP (business owners policy), you'll want to avoid the consequences of being under insured.

Accidents can destroy your business if you're not properly insured.

Contractors may not have the appropriate level of insurance coverage required by law, such as workers' compensation or general liability insurance, exposing them to potential legal and financial risks.

Accounting Mistake #8 - Improper change order documentation

When you have change orders, you'll want to document them properly for taxes, accounting & compliance reasons.

Contractors know more than accountants in this matter, but when a dispute arises, it's really important to have the change orders officially documented, with proper customer approval and costs.

The last thing you want is for your team to start adding in change orders, only to have the customer dispute them after they're completed.

You also want to keep proper documentation so that the profit and loss report and job costing are accurate.

Contractors may not fully understand the importance of properly documenting change orders and could unknowingly approve work without the necessary documentation, leading to potential disputes and financial losses.

Accounting Mistake #9 - Not reporting cash transactions

We all know the temptation of not reporting cash jobs.

It's vitally important to a business that they properly report all the income they earn.

Yes, paying 0% tax is more attractive than paying 15-40% tax, but breaking the law can legitimately sacrifice your entire operations.

When your company operates outside of the law, your team will start to know about it.

As word spreads that cash jobs get discounts, or that fishy transactions and bonuses are handed out occasionally, it's not uncommon for a disgruntled employee to call the IRS, State or other tax authority to blow the whistle on your illegal activity.

If you want a business that thrives over the long haul, we suggest you always obey the law.

Some contractors may not realize the importance of reporting cash transactions, which can lead to underreporting income and tax evasion unintentionally.


To sum up, dodging IRS audits as a contractor means tackling several obstacles, such as properly categorizing workers, keeping precise records, and reporting all transactions, even cash-based ones.

At Whyte CPA Tax & Accounting, we offer extensive services to help contractors handle these challenges, reduce taxes, and expand their businesses sustainably.

Keep in mind that this article serves as a guide and not specific legal advice - for personalized help, consult with a tax expert like us.

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