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The tax season this year has passed, but we cannot as yet heave a sigh of relief
from the possibility of an IRS tax audit. An IRS audit is unpleasant at best,
and terrifying at worst. In addition to the prospect of someone poking at every
aspect of your business, the cost of defending yourself at an audit--whether or
not additional taxes are assessed--can be significant. Plus, you may be levied
with unexpected unpaid taxes compounded by interest and penalties, which can
play havoc with your budget.
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The IRS conducts three types of audit: correspondence audits, office
examinations, and field examination. Correspondence audits are
computer-generated adjustments resulting to discrepancies in what you reported
that you can respond to by mail. Office examinations are when you or your tax
specialist are requested to appear at an IRS office with your records. Field
examinations are when an IRS agent visits your premises and personally checks
your claims (for home office deductions, don’t be surprised to see an IRS
agent with a yardstick at hand to measure the room that you claimed as your home
office).
The key to deflecting an IRS audit is to keep impeccable records. But what
are the items that raises the red flag for the IRS, which you should avoid? Here
are a few of them:
1. High Schedule C losses from part-time
businesses. If your income is
consistently low, or if you are experiencing losses, the IRS may consider
reclassifying your business from “for profit” to “hobby.”
Reclassification of a sole proprietorship as a "hobby" or "not
for profit" activity would cause disallowance of deductions that resulted
from losses. You therefore need to prove that your business is indeed ”for
profit,” often by: (a) showing that you are carrying its activities on a
businesslike manner; (b) the amount of time and money spent on the activity
indicates your intention to make it profitable; (c) you have the skills and
knowledge to make it work; and (d) you can expect to make a profit in the
future.
2. Large deductions relative to
income. If you are claiming for a $10,000
business travel deduction for an answering service business grossing $20,000 a
year, it may be likely that you will catch the eye of the IRS auditor. The IRS
usually checks unusually large travel and entertainment deductions. Other items
that catches the attention of the IRS include: unreasonable compensation, high
bonuses and compensation perks (e.g. club memberships, apartments or cars).
3. Incomplete or incorrect reporting. This includes making overt mistakes on
your return such as errors in math or incorrect Social Security number. Expect
to hear from the IRS if you are not reporting all your 1099 income.
4. Far-fetched business deductions. The IRS understands that entrepreneurs
may have a hard time separating their business from personal finances. So they
look out for deducted items that have nothing to do with the business. If you
are a virtual administrative assistant, where you provide support to clients
over the phone and the Internet, may have a hard time justifying hefty travel
deductions from their income tax returns.
5. Payments to family members as employees. Remember to keep records of when
family members work and what they do
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