Avoid­ing an au­dit of your busi­ness?

The Denver Post - - BUSINESS - By Gary Miller 5. Claim­ing busi­ness losses year after year. Gary Miller is the CEO of GEM Strat­egy Man­age­ment Inc., an M&A con­sult­ing firm, ad­vis­ing mid­dle-mar­ket pri­vate busi­ness own­ers pre­pare to raise cap­i­tal, sell their busi­nesses or buy com­pa­nies. H

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.

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