Avoiding the Audit Nightmare

Small business owners face a higher IRS audit risk - here's what you can do.

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By Steven D. Strauss

It seems to many small business people that the IRS audits them quite often. And it's true. Small businesses, especially sole proprietorships, are audited more often than almost any other group, and the results are usually not good. In most cases, the audited business has to pay additional taxes. Moreover, the IRS is now recovering more than four times as much money as it did ten years ago thanks to superior software.

It would behoove the small business owner to know how to avoid getting audited. So, here are the top five things the IRS looks at when deciding whether or not to audit. (Note: Each factor listed below is equal to each other; this is not a weighted list.)

  1. Self-employment: If you work for yourself, the odds are four times greater that you will be audited. Why? Because in most cases, the self-employed are obligated to disclose their income based on the honor system, whereas an employee has an employer whose filing lists how much the employee was paid. There is a check and balance for the employee that is not present for the self-employed.

  2. Substantial gross income: If you gross more than $100,000 a year, the odds are better that you will be audited.

  3. Odd deductions: Trying to deduct for things that are not normally part of your business is not smart and may trigger an audit. For example, an auto repairman's tax return that attempts to deduct a trip to Hawaii as a business expense may seem peculiar. Now it may indeed be a legitimate expense; all I am saying is that it may look strange to IRS auditors.

    By the same token, be careful about exceptionally high deductions in comparison to the rest of the return. Example: You make $20,000 and your mortgage interest deduction is $10,000. That seems to indicate hidden income, no?

  4. Intent to mislead: Be sure to sign your return and not leave any important questions blank.

  5. Round numbers: If you list your income as say, $50,000 even, this would indicate that you are not keeping accurate books or are fudging on your returns. Either way, it's a red flag.

    So, is there anything you can do to avoid an audit? Here are a few tips:

    • Don't over-deduct. This tip is related to the "Odd deductions" rule above. Be careful of listing every single receipt you have, no matter how tangential, as a deduction. Studies have shown that taxpayers who deduct expenses of more than 65 percent of their gross income are often audited. Taxpayers who deduct 50 percent and less of their income as expenses are audited far less often.

    • Prepare a proper return. Have it typed and filled out in full. A messy return, or one full of cross-outs or Whiteout is suspicious.

    • Avoid showing a loss. Losses do happen and they must be reported. But a business that shows a loss for several years in a row is a business that should be out of business. If it's not, something's fishy.

Finally, be prepared to back up anything you do say in your tax return just in case you are audited. Keep receipts, date books, calendars, contracts, checkbooks, cancelled checks, automobile logs - anything that may later help you prove your point. They can go a long way toward getting you out of a jam should an audit arise.

If you are having a problem with the IRS, you might want to pick up a copy of my latest book The Complete Idiot's Guide to Beating Debt.

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