IRS audits of small business tax returns are up - way up, and headed even higher.
The Internal Revenue Service has said loud and clear that it believes
roughly $100 billion of income from small business, home office and
other solo-operator sources goes unreported each year.
As a result, the tax collecting agency has amped up an enforcement
effort aimed squarely at a wide range of small business returns,
including S-corporations, LLCs, partnerships and especially sole proprietors, who generally use a Schedule C to a personal 1040 return to report business-related income. The audit stats get ugly. Sole proprietors - the most dominant form of small biz ownership - are 10 times more likely to be audited than other business entities.
It’s little wonder. The IRS spends less
to pursue big corporations, wealthy tax cheats and money-laundering
drug lords combined than it does going after small business owners.
If there’s “good news” here, it’s this: You can lower your odds of a
tax audit by taking certain steps with your tax return, and avoiding
others - you just need to be “DIF” score savvy. DIF is hush-hush
Fed-speak for “Discriminate Information Function,” the super secret IRS
sauce that decides if your small business related tax return is ripe
for an audited. While DIF details are, well, secret, the
steps below can help you avoid the audit hook. Each choice you make
(how to file; when to file; what deductions to claim) has an impact on
your audit odds. Here are 16 things you can do:
- 1. Be accurate, thorough, neat and on time (but not early). Sloppy returns, math errors and rounded numbers raise flags. Using tax preparation software
makes your return look more professional and helps you avoid mistakes.
Filing early only gives the IRS extra time to look it over. Accuracy
starts with keeping good records; if the IRS ever questions anything on
your return, the burden will be on YOU to prove it’s right. If your
records are sloppy, this will be difficult.
- 2. Avoid filing electronically. Sure, electronic
tax return filings are convenient, and in some cases even required. But
the IRS hires temps to enter data from millions of paper returns, and
they capture only about 40 percent of the info. Electronic filing gives
IRS fast access to 100 percent of your return.
- 3. Explain yourself clearly. Avoid vague expense
categories such as the infamous category some business owners use
called “miscellaneous.” If your business is claiming unusual deductions
of some kind - anything an IRS reviewer might not have come across a
thousand times before — provide an explanation or documentation.
- 4. Make your estimated tax payments and issue 1099 and W2 forms on time. Late quarterly and estimated payments,
non-payments and underestimated amounts draw IRS ire. Know the
deadlines and meet them. File 1099s and W-2s using easy online tax
services such as FileTaxes.com which are cheap and easy.
- 5. File on time: This is kind of a no-brainer.
Late returns raise flags. It’s easy to file for an extension, so
there’s little reason to miss the initial deadline. Just remember that
any money you owe is still due by the original filing deadline; the
extra time is for doing the paperwork.
- 6. Beware of your income-to-deduction ratio. Your
tax audit odds for a small business rise if the difference between
expenses and income exceeds about 52 percent. But total deductions are
only part of it. One especially large deduction can also raise flags,
even if others are small or in line with other businesses in your
industry.
- 7. Inc. yourself. Sole proprietors who file a
Schedule C for each business get audited most. To avoid the higher risk
of sole proprietor audits, consider making your business a corporation or limited liability company (LLC).
- 8. Hire a CPA or other tax pro. Tax rules that
affect small business are impossibly complex, far-reaching and
downright confusing. Even for relatively straightforward situations,
getting professional tax preparation advice can be a huge help in
avoiding audit triggers for your particular case or industry. Check
online sources for different types of accounting firms and CPAs specializing in your area.
- 9. Be wary of taking a home-office deduction. Tax
returns that include a deduction for a home office are a prime IRS
target, so if you plan to take a home-office tax deduction, make sure
you know the rules. A home office must be a completely separate room or
area used exclusively for business. Here again, a CPA can be invaluable
in helping you do it right, or perhaps deciding that the benefits
aren’t worth the hassle.
- 10. Avoid the independent contractor trap: Another
favorite IRS target - one they are convinced yields a lot of extra cash
- is miss-classified workers. If your business uses freelancers and
other types of independent contractors, make absolutely certain they
qualify for independent contractor status or the IRS may determine they really are employees and stick you with a big bill for back payroll taxes plus penalties.
- 11. Watch those startup cost deductions: Many
startup entrepreneurs and new business owners assume that money they’ve
spent to get the business up and running can be deducted immediately.
But that’s not always the case - many startup costs must be
“depreciated” over time. (Check out the latest “bonus depreciation” tax rules for small business included in the 2009 economic stimulus bill.)
- 12. Don’t “forget” to report income: The one thing
the IRS hates above all else is unreported income. And don’t kid
yourself - the tax agencies are far more sophisticated about tracing
money than they’ve ever been. Also remember that the IRS has extensive
data on typical income levels and deductions for every type of business
that exists. If yours is out of line with others like you, an audit
could result.
- 13. Don’t mix personal and business deductions:
The IRS is on the lookout for small business owners who try to deduct
travel, entertainment or other costs (cell phones, merchandise, etc.)
that are really personal, and not business related. Remember that only
business-related expenses can be deducted. Make sure you understand the
rules on what portion of business entertainment costs are allowable as
a deduction. And avoiding taking mileage deductions for personal use of
a vehicle… another IRS audit hotspot.
- 14. Make your hobby a true business: If the
business you are claiming all those deductions for looks more like a
hobby to the IRS, you could trigger an audit and end up owing back
taxes. A real business has revenues at least some of the time, and
looks, acts and spends like a business as well.
- 15. Report barter and auction income: The fair
market value you receive through business barter transactions may
indeed be taxable, even if you did not receive cash. Likewise, income
generated from selling items via online auction websites needs to be
reported.
- 16. Be honest. Every year, the IRS gets better at
using high-tech means to track your business income. And some things
are just obvious. If you claim lots of expenses, but show little
revenue to pay for them, the tax folks get curious.
Link to original post