The tax season is tough, but even tougher if you face 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.
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.
You are allowed to hire your children to work for your business. However, remember to keep records of when family members work and what they do.
Recommended Books on How to Avoid a Tax Audit of Your Business:
- Surviving an IRS Tax Audit
- Tax Deductions for Professionals
- IRS Income Tax Audits: A Mini-Course in Avoiding, Preparing For, and Getting Through an IRS Income Tax Audit (T. Rex Tax Series, A TforTaxes.com Publication)
- Lower Your Taxes Big Time 2013-2014 5/E
- The IRS Problem Solver: From Audits to Assessments–How to Solve Your Tax Problems and Keep the IRS Off Your Back Forever