Small business owners frequently prefer to set up as small business partnerships to avoid the expenses and bureaucracy involved in forming a corporation. A surge in these types of partnerships over the past few years has brought this sector under increased IRS scrutiny at tax time. Flow-through entities in particular have attracted the auditors’ special attention. Flow-through or pass-through business structures include both S corporations and sole proprietorships. Income from these businesses is often filed as individual taxpayer filings. Auditors are especially keen to look carefully at these filings.
Professional help is a must if crunching numbers is your least favorite task. A professional tax advisor also can help you avoid problems and pitfalls. Here are some of the common red flags that land people in trouble.
- The rule of thumb is don’t attract attention. If your income or deductions look radically different from those of your peers (similar businesses with the same income level), you run a high risk of attracting additional scrutiny.
- Businesses that deal predominately in cash transactions always raise more questions than others. Was all the income reported? Any type of business involving tips – bars, restaurants, hair salons and spas – are an obvious target.
- S corporations and single proprietorships that list a lot of deductions are a red flag – especially if they appear to be a big percentage of your declared income. Take all of the legitimate deductions you can, but bear in mind that you should have records to substantiate every claim.
- Incomplete returns attract attention. Request an extension if you need more time to file a complete return, but try to file a complete return the first time. Amending returns, even though you might be within your legal rights to do so, is likely to pique IRS inspectors’ interest, especially if the revisions are in your favor.
- Mistakes, carelessness or bad math will also bring attention. So will omissions – intended or otherwise. Double-check your figures; a typo can trigger an audit even if it is unintentional. It’s also wise not to enter round numbers on every line. This creates the impression that your figures are guesstimates and might encourage the IRS to ask to see your financial records. If you make a genuine mistake, the IRS is more likely to settle without conducting a full audit if the error appears to be genuine and if you cooperate fully.
- Using a single checking account for business and personal business is asking for trouble. If your business filing is audited, there is a strong likelihood that the IRS will take a long, hard look at your personal tax return, too. Maintain a separate bank account and credit cards for your business. That way, it’s relatively easy to keep track of expenses and income – showing how income was earned and where expenses occurred in support of business operations. If an auditor pays a visit, you will need to show how the income came in and what checks were written in support of your business endeavors.
If your business is complex or you lack the time to do a thorough job, seek help from a tax advisor well before crunch time. Nothing can guarantee that you won’t get audited, but a professional approach to filing and documenting your taxes should help spare you a great deal of costly trouble.