How To Avoid An IRS Audit Of Your Business – Cash Flow Management Tip

The IRS audits only a small percentage of business and personal tax returns annually, because they used to lack the manpower to do extensive audits. However, part of the growth of government has been over 52,000 IRS agents added to the governments payroll. Why? You guessed it; to do tax audits. Our current government is desperate for tax revenue and they will be scrutinizing returns like never before. There are “Red Flags” the IRS tax return scanning system picks up that could target your corporate or personal return for an IRS tax audit.

If your return is selected for review, you have nothing to worry about if you haven’t mis-stated the numbers on your return, and you have receipts and notes to back you up.

Despite the fact the odds of you getting audited may seem low, those odds increase dramatically based on your income and the types and amounts of deductions you claim. The higher your income the more likely your return will be selected, math errors make you more suspect, and taking larger than normal amounts of deductions in certain categories can trigger an audit.

Commonn IRS Audit Triggers

Not Reporting All Taxable Income

It is very dangerous to not report all of your income. Because the IRS gets copies of all 1099s and W-2s you receive, they will be looking closely at whether you reported all of your income. The new law that went into effect in 2011 even has your merchant services supplier sending out a 1099-K to report all the income run through your merchant account from customers who used their credit and debit cards. Be sure you give the 1099-K to your corporate tax preparer and it is wise to break out that income on your Profit and Loss statement from the cash income you received.

IRS computers are pretty accurate at matching the numbers on the forms with the income shown on your return. A mismatch sends up a red flag and causes the IRS computers to spit out a bill. If you receive a 1099 showing income that isn’t yours or listing incorrect income, get the issuer to file a correct form with the IRS. Put all communication in writing and keep the documentation of the communication that goes in both directions.

Operating a Cash Business and Under-Reporting The Income

Lots of business owners run cash intensive businesses – restaurants, bars, hair and nail salons, taxi services, etc. These cash businesses are a target for the IRS to scrutinize and they are masters at asking questions in a manner that can indicate whether or not you are reporting all of the cash income. Don’t under-report the income. The fines, penalties and interest you will be made to pay is just not worth it.

Falsely Claiming A Home Office Deduction

In the past, the IRS has been very successful driving down the deductions some take for the home office, and increasing the amount of tax they collect for the government. However, if you do qualify for this deduction, you can deduct a percentage of your rent, property taxes, telephone, utilities, insurance and other costs that are legitimately allocated to the home office, so take advantage of it if you qualify.

There are some conditions to qualifying: you have to use the space exclusively and regularly as your principal place of business. That makes it difficult to successfully claim some common areas of the house or apartment as a home office, even if you also use the space to do your work. “Exclusive use” means that a specific area of the home is used only for trade or business, not also for the family to gather in for evening activities. To learn more about this or any tax topic visit the IRS website.

Claiming Personal Meals and Entertainment as a Business Expense

A Schedule C filed by a sole proprietor can be a gold mine for the IRS. Sole proprietors often claim excessive deductions, especially for meals and entertainment. Claiming big deductions for these items is like waving a red flag at the IRS. Corporations are also scrutinized in this category, but not as much as a Schedule C filer.

IRS agents are always on the lookout for personal meals or entertainment taken as a deduction. To qualify as a legitimate business meal or entertainment deductions, you are required to keep a detailed written record for each expense, including the amount, the place, the people who were at the meal, the business purpose and the topic(s) of discussion. Keeping receipts for the meals and entertainment is part of the documentation and a good practice since a meal is only 50% deductible, but the tip is 100% deductible at a legitimate business meeting, so split the expense in your accounting records between the meal and the tip.

When you travel, any expense for lodging over $75 requires a receipt. I have my clients keep ALL travel receipts, because if they get audited and there is no receipt the deduction can automatically be denied by the IRS.

Business Use of a Vehicle Claimed at 100%

Vehicle expenses are another audit trigger for the IRS. If a corporate Board of Directors has agreed to assign a vehicle to the corporation it’s one thing, but the use of a personally owned vehicle used by a sole proprietor is a horse of a different color.

Whenever a vehicle is depreciated using Form 4562, you must state what percentage of its use during the year was for business. IRS agents know that it’s highly unlikely for a sole proprietor to actually use a vehicle 100% of the time for business, especially if it is the only vehicle available for use by the individual. Keep detailed mileage logs and calendar entries for the purpose of every business mile driven, because having sloppy records makes it easy for the IRS agent to disallow your vehicle deduction.

Too Many Years of No Profits

Your chance of triggering an audit increase dramatically if your Schedule C business appears to be nothing more than a hobby to garner deductions, especially if you also earn wages as an employee. You are required to report any income from a hobby, but your losses cannot exceed the income.

For corporations and sole proprietorships, the IRS expects you to make a profit after a startup period. If you fail to make a profit after a reasonable startup time for your type of business, the IRS can require that you prove you have a legitimate business instead of having just a hobby.

Not Paying Yourself A Payroll Check – For Owners of Corporations

For the owners of a corporation, with few exceptions, the IRS expects you to be on the payroll. They frown upon a business owner taking all of their income as direct distributions, also known as owner’s draws. The government wants you paying your fair share of social security and Medicare payments, whether you ever see a dime of social security in your retirement or not. So never putting yourself on payroll is a sure way to eventually trigger and audit. There isn’t much of a defense you can mount as to why you paid yourself only cash instead of running at least some of it through payroll.

Claiming Deductions That Are Higher Than Average In Certain Categories

If business deductions on your tax return are disproportionate to your income, that can trigger an IRS audit, likewise putting legitimate business deductions in the wrong categories can inadvertently trigger an audit as well. If you have the proper documentation for the expense it won’t be denied, but the headache of going through a high-stress audit is not worth it.

The best thing you can do for yourself is to understand the basics of accounting as it pertains to reporting on a tax return so you’ll be able to tell if your bookkeeper or accountant knows and understands both accounting and tax law.

Bookkeepers who claim they know accounting, but really don’t know, can trigger an audit just by the way they enter your transactions in the accounting software. A typical example is posting transactions in the “Office Supplies and Expenses” category that belong in a “Cost Of Goods Sold” category. To a bookkeeper who doesn’t understand accounting and tax laws, the “Office Supplies and Expenses” category is often used as a catch-all for any transaction they don’t really understand how to account for. Something as simple as an over-inflated Office Supplies category that is higher than average based on your income and your type of business can easily trigger an audit.

If you don’t understand the basics, then you will have a hard time directing a bookkeeper to keep your books properly and you’ll miss the fact they are making mistakes that could cause you problems with the IRS. If you have a bookkeeper or accountant on your payroll and you are wondering if you have the right person who really knows their stuff, or you are having trouble with the person, my accountant colleague, Kathleen Lettau, offers a free guide on her website titled “9 Reasons To Hire A Different Accountant or Bookkeeper.” You can get it by going to http://perfectaccountingservice.com/

If you are interviewing a bookkeeper or accountant to work in your company, I have developed a simple, inexpensive test you can purchase to give the bookkeeper or accountant you intend to hire to insure they understand what they are supposed to do. To learn more about this, contact me at https://www.cashflowmojosoftware.com/contact/

The IRS may target your return for review at some point, but if you have the proper documentation for your deductions, don’t hesitate to claim them. There’s no reason whatsoever to pay more tax than you actually owe. That’s just smart cash flow management.

How To Avoid An IRS Audit Of Your Business – Cash Flow Management Tip