How to Avoid a Tax Audit
How to Avoid a Tax Audit (and What to Do If You’re Audited)
by Neal L. Lewis, CPA
Did you know that mid-year is when the Internal Revenue Service decides which tax returns will be selected when auditing small business tax returns filed in the spring? Now is a good time to review how you can make your next income tax return more audit-proof.
The IRS does not reveal the exact selection criteria it uses, but certain aspects of a return are likely to trigger an audit. First of all, the agency scrutinizes certain types of businesses more closely than others.
Owners of highly-cash-based businesses, such as car washes or laundromats, need to be particularly fastidious about their tax returns. Self-employed individuals using Schedule C on their tax return are also highly scrutinized by the IRS. Keeping accurate records throughout the year is important. Because it’s easier to hide income in this type of business, the IRS is especially vigilant. Any business that reports low income, yet significant business deductions, for example, can look suspicious and attract attention.
Because the IRS handles more than 183 million income tax returns a year, it relies on a computer program to spot potential problems. The “Discriminant Index Function,” or DIF, scans returns for common “red flags.” Examples include: unreported income or excessively high incomes compared to the previous year; excessive home office deductions; and money held in foreign accounts.
Some Do’s and Don’t’s
> Do document personal and business expenses separately. If you travel to a conference in Hawaii and then take a few days of vacation, you’re not allowed to take a business deduction for the entire trip. IRS guidelines spell out how much is deductible.
> Don’t be afraid to count legitimate entertainment expenses. Taking a customer or prospect out for a meal or golf outing is a great way to build the business relationship. Keep good records and avoid overly lavish parties.
> Do count business mileage, but only if you own the vehicle! I know someone who claimed a significant amount of business mileage, but it was later revealed – through an audit – that the vehicle titles were in someone else’s name. He not only had to pay additional tax, but also a penalty.
> Don’t misreport compensation. The IRS looks at what a business owner is being paid and compares it to standardized salary tables. Some owners, for example, are tempted to minimize their income or try to escape paying payroll taxes by taking out money through means other than compensation. This is an issue for S Corporations, not so much for Schedule C’s or partnerships.
> Do ensure your life style reflects the income reported on your tax return. The auditor may investigate your personal spending habits to determine if the income reported on your return is sufficient to maintain your personal spending habits. If not, be prepared to prove other sources of cash, such as an inheritance, new loans, or a decrease in investments and savings.
> Do proper planning to minimize taxes. Take this important step before the end of the year, when it may be too late to improve your tax position. Ideally, you should sit down now and plan your business operation for the upcoming year. And if you intend to sell the business, you should begin planning for that three to four years ahead of time to help minimize your taxes.
If You’re Audited
The chances of being auditing are very low, unless you’re fortunate enough to have an income of $10 million or more. Only about one percent of all individual income tax returns filed in 2007 were audited. That compares to ten percent of filers in the $10 million or more bracket.
If you are contacted by the IRS, do not fear. The #1 rule here is to contact your tax preparer. Individuals who represent themselves are unaccustomed to it and can make mistakes under the pressure of scrutiny. A tax professional is comfortable working with IRS agents.
Here’s an example of what can go wrong. “Fred” decides to represent himself during an IRS examination. When asked “Do you have any unreported income?” he says “No.” Later, in pouring through his records, the IRS finds income he innocently forgot to report. Now he is faced with the potential of a criminal charge because he “lied.” His tax preparer would have avoided that situation by answering “Not to the best of our knowledge.” When the unreported income was found, the mistake would be judged as an error, not a lie.
As long as you and your CPA are following the tax laws, you should not be concerned if your return is selected for an audit. If it is, however, you should sail through the audit with flying colors!
Neal L. Lewis, CPA, is managing partner with Lewis Barlett Klees, PC, one of central PA’s leading accounting and business development firms, with offices in Bloomsburg, Lewisburg and Milton. The firm offers auditing, accounting, tax, and management advisory services to government, non-for-profit agencies, and private businesses, in addition to tax preparation for individuals. Free tax and business tips are available at www.LewisBarlettKlees.com.
