Warning to business owners: Danger ahead. The IRS has announced it’s stepping up audit efforts with a renewed emphasis on examining returns of small business entities. Watch out for these five danger signs that could lead to IRS inquiries:
1. Target industries: What’s your line?
The IRS periodically releases “audit-technique guides” to help its examiners conduct audits. For example, in addition to the dozens of audit-technique guides already on the books, it has issued publications for the construction industry, auto dealerships and veterinarians.
It’s no accident that the IRS singles out particular industries and professions. The agency considers those businesses ripe for abuse.
Alert: If you’re in a targeted field, your business faces a greater audit risk.
On the plus side, an audit-technique guide can provide valuable insights into the violations the IRS expects to uncover. Treat an audit-technique guide as a friend, not a foe.
Tip: You can find the audittechnique guide for a particular industry at www. irs.gov/businesses/small/article/0,,id=108149,00.html.
2. Sole proprietors: not small potatoes
Traditionally, sole proprietors have operated under the IRS radar. Not anymore. The agency now believes that particular group accounts for more than twice the unreported tax as the largest corporations. Accordingly, the IRS is turning up the heat on Schedule C filers.
Alert: For sole proprietors with gross receipts of $100,000 or more, the audit rate for the 2005 tax year was 3.65 percent, up from 1.86 percent the prior year and a whopping 149 percent rise dating back to 2003. (IRS 2005 Data Book, Pub. 55B)
Other sole proprietors, including individuals operating a sideline business, aren’t immune from the audit threat either. The examination rate for those with gross receipts below $25,000 was 3.68 percent for 2005; it was 2.21 percent for those with between $25,000 and $100,000 in gross receipts.
Tip: Consider switching your business ownership to a pass-through entity such as an S corporation. For 2005, the audit rate for that group was only 0.31 percent: about one for every nine sole proprietors audited.
3. Owner compensation: Let’s be ‘reasonable’
If you’re the owner of an incorporated business, you might think it’s OK to pay yourself whatever you’d like. Not quite. The IRS will object if it considers your salary “unreasonable.”
Alert: The agency often goes to the mat to prove its point on reasonable compensation. That’s why those cases often end up in Tax Court.
The IRS may vary its approach depending on whether you own an S corp or a C corp.
- If you own a C corporation, the agency may deem the salary excessive. It may suspect the owner is trying to “disguise” amounts that should be paid out in nondeductible dividends as tax-deductible compensation.
- If you’re an S corporation owner, the IRS could say that you’re underpaid. You can avoid employment taxes by keeping more cash in the company’s coffers.
Tip: Safeguard compensation amounts by documenting what other employee-owners are paid in comparable situations. This is the best proof you can have if the IRS ever challenges your setup.
4. Employment taxes: fighting for independence
A small business may use independent contractors for services in lieu of hiring regular employees. One key advantage: The business isn’t liable for employment taxes paid to independent contractors.
Alert: IRS investigators traditionally target this group. Be prepared to prove that outside workers are not really employees.
The distinction essentially boils down to control. If you can control what the worker does and how and when the work is done, he or she is generally considered an employee.
Tip: Under so-called Section 530 relief, you can treat workers as independent contractors if you have a “reasonable basis” for doing so. For details, see Pub. 1976 at www.irs.gov/pub/irs-pdf/p1976.pdf.
5. T&E expenses: Toe the line
Travel and entertainment (T&E) deductions have long been a prime target of IRS auditors.
Keep adequate records concerning the amount, time and place and business purpose for T&E expenses. For entertainment expenses, you must also establish the business relationship of the person (or people) being entertained.
The IRS requires documentary evidence, such as receipts or credit card statements, for expenses of $75 or more.
Don’t be misled: Take legitimate deductions. But if you fall into the audit danger zone, be prepared to defend your claims.
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