Many small-business owners live in fear of an audit by the IRS, but the reality is that relatively few will ever have to go through an exhaustive examination of their books, invoices and receipts. What’s more likely is that they’ll catch the notice of IRS employees with omissions or mistakes — or by claiming too much for deductions such as entertainment or home office expenses.
“If your arithmetic is wrong, or your calculations are wrong, those are the types of things that create inconsistencies and often create exams that you don’t need,” said Steve Hurok, tax director in the Woodbridge, N.J., office of the accounting firm BDO Seidman LLP.
The IRS doesn’t have enough staff to do a high number of full-blown audits. It’s much more likely you’ll get a letter from the IRS questioning an item on a tax return — and, accountants say, the more questions your return raises, the greater your odds of having to go through a more exhaustive examination.
As IRS employees go over a return and the information on it is entered into the agency’s computers, the return is given a ranking called a discriminant function system score. The score is reached by comparing the income, deduction and expense numbers on the return with other returns in a similar tax bracket or industry, and deviations from the norm can drive a score higher and make a return more vulnerable to an audit.
“If things are very much out of whack after the return’s been inputted, it could kick out,” said Gregg Wind, a certified public accountant with Wind Bremer Hockenberg LLP in Los Angeles.
A high score doesn’t necessarily mean the big audit — it may just mean that income, expenses or deductions, for example, are questioned. Still, you really don’t want to call attention to your return.
Computers also help IRS employees make their most common inquiries, when income reported on a return doesn’t match up with income reported to the government, for example, when income reported on a 1099 form doesn’t appear on a return.
The government is also on the lookout for expenses and deductions that appear to be excessive. Deductions for home offices, vehicles that are used for both business and personal purposes and entertainment expenses are among those that can invite a closer look. You should be aware that the IRS has its own rules about what is a reasonable expense or deduction, and agency employees are well aware of the abuses that tend to be popular in some industries.
Perhaps a good rule of thumb is, if you’re hoping to get away with something, don’t try it.
“Do what’s right and reasonable and report as accurately as you can,” Hurok said. “If you do things that are on the borderline or beyond, that’s when you get into trouble.”
If you have an S corporation, in which the corporation does not pay income tax, and the profits are passed through to shareholders in a fashion similar to a partnership, the IRS is looking for anomalies such as a huge dividend being paid to shareholders and relatively little in the way of salaries. That’s a tip-off to the government that shareholders might be trying to avoid employment taxes.
Hurok noted that if the IRS finds a discrepancy between the income attributed to a taxpayer on a company’s Form 1120S, U.S. Income Tax Return For an S Corporation, and shareholders’ 1040s, that could set up the company for a closer examination in subsequent years.
Wind noted that the government is also wary of very small businesses than incur losses for more than two or three years running; depending on the kind of business, the IRS may decide that what you have is a hobby, not a business that’s trying to turn a profit.
“If you fall into the hobby loss rules, the onus is on you to prove that you really have a profit motive,” Wind said.
A good way to avoid making mistakes is to keep good records and to use tax preparation software that will avert mathematical and clerical errors. You also should seek professional advice if you have very large expenses and deductions.
One of the biggest myths about small business audits is that getting an automatic extension of the filing deadline makes your return more likely to be more closely examined. Accountants almost universally say that isn’t so — and they note that some small businesses routinely get extensions to help manage their cash flow without inquiry from the government.
Moreover, Hurok said, don’t let concerns about an audit stop you from claiming all the deductions you’re legitimately entitled to.
“Some people say ‘I don’t want to report a loss this year, I’m afraid of an audit.’ If the loss is legitimate, you don’t need to be fearful,” he said.
Joyce Rosenberg covers small business issues for the Associated Press.
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