Printable Version

Audit-Proof Your Small-Business Tax Return

Look for Red Flags and Avoid Common Mistakes

There's no way to guarantee that your return will escape IRS scrutiny. But whether you operate your business as a sole proprietorship, limited liability company, or S or C corporation, there are steps you can take to sharply cut the risk of an audit.

Red Flags

The IRS definitely has identifiable audit targets. It looks more closely at certain issues than others and considers various positions taxpayers take on their returns as invitations to an audit.

Best defense: Know these audit targets well. Take steps to cement your tax return position so that if you're questioned, you have nothing to fear. Examples:

• Compensation. Owners of S corporations who perform services for the business should be sure to take a reasonable salary. Owners often skip salary so they can avoid paying FICA taxes. This is something the IRS always looks for when it audits an S corp return. A reasonable salary is based on the relevant facts and circumstances involved in a given situation. One consideration is to compare compensation paid to the amount the individual would have been paid by an unrelated company.

Owners of C corporations should not take more compensation than what they can justify as reasonable based on the nature and extent of the services they performed. C corp owners often inflate their salaries to increase the corporate deductions for them. In an audit, the IRS will disallow compensation that is not reasonable.

There's no one rule for determining what's reasonable. Factors that can be used include what the company would have to pay an outsider to perform the same work and what a hypothetical investor would permit as compensation so that he/she can obtain a return on his investment.

• Worker classification. The IRS is always on the lookout for misclassification of workers as independent contractors rather than employees. If the workers are independent contractors, the company avoids paying employment taxes. But you must treat workers as employees rather than independent contractors if you exercise control over how, when, and where they perform their duties.
Important: Treat all workers doing the same job in the same manner, as either employees or contractors. If you treat some as employees and others as contractors, the IRS can say they're all employees and assess employment taxes.

• Travel and entertainment (T&E) expenses. Even though you can now deduct only half of your meals and entertainment costs, the IRS still looks closely at these deductions. The auditor wants to know if you've written off personal expenditures as business expenses.
To convince an auditor that your T&E deductions are legitimate, have all necessary substantiation. For details of required substantiation of these expenses, see IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses, at www.irs.gov or call 800-829-3676.

What's not a red flag: Over the years, some steps taxpayers take have become known as red flags when, in fact, there is little evidence to support this view.

Example: Don't hesitate to request a filing extension if you want one. It's not likely to increase the chances that your return will be audited.

You can obtain an automatic extension without giving any reason for needing added time to file the return.

Mistakes to avoid

Each year, the IRS identifies a number of common errors found on taxpayer returns. If you avoid these mistakes, you'll minimize IRS attention to your return:

• Not completing the return. Failure to answer questions or provide information on the return can lead to further IRS inquiry and delay the processing of a refund.

Example: Take care to include the correct business code number, using the North American Industry Classification System, on the return. In one recent case, the IRS determined that a business was in fact a personal service corporation because the wrong code number was put on the return and, as such, assessed an additional tax.

• Failing to report income. The IRS is always on the hunt for unreported income. There are numerous audit manuals for agents to use in determining whether income has been omitted. The audit manuals under the IRS Market Segment Specialization Program are geared to specific industries. For details, visit www.irs.gov/businesses/small/article/0,,id=108149,00.html.

• Taking positions that don't make sense. Be sure to keep expenses in line with your type of business. A company may deduct the cost of four cars, for instance. If there are several salespeople, this may be reasonable. But for a retail establishment that does not make deliveries, the deduction may be excessive and the return may be flagged for audit. Similarly, what may be reasonable meal expenses for someone in sales would not be reasonable for a tradesperson.

• Failing to capitalize certain costs. Businesses want to deduct payments up-front, but the tax law requires certain expenses to be capitalized and written off over time. Claiming deductions for items that should be capitalized is a common problem and can lead to an audit.
Suggestion: Explore with your adviser the special options to write off costs up-front that might otherwise have to be capitalized. Example: Environmental remediation costs.

• Creating problems on state tax returns. Many states have tax rules that differ from federal law, and the failure to observe these differences may lead to an audit on the state level. For example, New York and several other states did not adopt bonus depreciation, a 50% first-year allowance for the cost of buying equipment prior to 2005. Be sure that state tax returns account for differences in state tax rules.

Work with accountants

Understand the limits of what accountants can and cannot do for you. Some business owners may want to be aggressive in their filing positions, but accountants have a professional responsibility to follow the tax rules. They risk preparer penalties if they flout these rules.

Do not ignore any IRS inquiries about a return, however trivial they may seem. Inform your accountant immediately of the IRS notice and be sure to respond promptly.

Caution: Some accounting firms advertise themselves as giving "audit-proof" services. They may indeed pay the IRS penalties that result from positions taken on a return, but they can't protect you from being selected by the IRS for a tax audit, nor will they cover the tax or any interest you may owe as a result of the audit.