Avoiding an audit of your business?
It’s tax season. Most business owners have either filed a 1040 tax return or an extension. Still, the question looms: Is this the year I get audited?
Every year the IRS sends notices to thousands of taxpayers informing them they have been selected for an audit. An audit can be a scary situation, one most small business owners try to avoid. Audits involve the government prying into your personal financial affairs, requesting sensitive financial information, and at times making you feel as if you’ve done something wrong. Audits are time consuming and can be expensive — you may have to pay penalties and interest assessed on a tax liability and the cost of professional tax counsel to help you through the process.
How can you minimize your chance of being audited? It helps to understand how returns are selected. Since the IRS doesn’t have the budget to audit everyone, the agency assigns a numeric score from two scoring systems to every tax return. It is looking for under-reported income and over-stated deductions. The higher your score, the higher your chances for an audit. Here’s how it works.
All tax returns are entered into a computer. The IRS uses one computer program called the Discriminate Inventory Function system and another program called the Unreported Income Discriminate Index Formula to determine the probability of inaccurate information and under-reported income. Each score is evaluated in conjunction with the other.
Different formulas are used for different types of tax returns. The IRS does not reveal the exact criteria and formulas used to score tax returns, but some information is known. It is important to note that complex tax returns have a higher chance of being audited — because complex tax returns usually are filed by high-income earners.
There are eight common audit triggers that you should keep in mind as you work on your tax return.
1. Higher than average income.
Taxpayers with incomes exceeding $200,000 have a greater chance of being audited than taxpayers of average income. If this applies to you, keep meticulous financial records in case you are audited.
2. Disproportionate deductions.
The IRS uses schedules to determine how much is too much for various income brackets. For example, if you claim charitable deductions that are out of line with your income bracket, watch out. The IRS will want proof.
3. Rounded or averaged numbers.
If your total deductions are $15,998, don’t report the deduction as $16,000. The IRS agent reviewing your return tends to believe that rounded or averaged numbers are “sloppy” and that the rest of your return may contain inaccuracies.
4. Home office deductions.
These are often abused by business owners. Even though the IRS has simplified the home office deduction method, requirements necessary to take the deduction have not been relaxed. You can still only claim a portion of your home office if it is exclusively dedicated to your business.
The agency knows some people claim hobby expenses as business losses, and under the tax code, that’s illegal. If your business claims a net loss for too many years, or fails to meet other requirements, the IRS may classify it as a hobby, which would prevent you from claiming a business loss. If the IRS classifies your business as a hobby, you’ll have to prove that you had a valid profit motive if you want to claim those deductions.
6. Filing a Schedule C. The IRS looks closely at this form. A Schedule C (Form 1040) is used to report income or losses from a business you operate or a profession you practice as a sole proprietor. An activity qualifies as a business if your primary purpose is for income or profit. You have to be involved in the activity with continuity and regularity. Make sure that you have careful documentation to justify all of your deductions.
7. Excessive deduction for business entertainment.
We all know stories about someone who takes friends out to dinner and then writes it off as a business expense. So does the IRS. Don’t take your family on a business trip and try to write off their expenses. If your return has higher-than-average entertainment expenses compared to your income, you could find yourself sitting across the table from an IRS agent. You will need receipts for all expenses greater than $75 when traveling for business.
8. Claiming your vehicle as 100 percent business use.
Deducting both the IRS standard mileage rate and actual vehicle expenses will cause the IRS to come knocking. In addition, if you claim 100 percent business use on the depreciation form for your vehicle, you’ll need precise records that include mileage logs, dates and the purpose of every trip.
Your best defense against these eight triggers is keeping complete and detailed records. If you have questions about filing your return, seek tax counsel or ask a professional tax preparer. If you have already filed your return and think there could be problems with it, consider amending your return.