Tip of the Month for March 2007

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TIP: Avoid Audit Angst
As tax filing deadlines draw closer, the specter of an audit notice from the Internal Revenue Service looms larger. Small business owners suffer from tax jitters more than individual filers - and with good reason. The IRS believes that a sizeable chunk of unreported tax revenue - an estimated $ 110 billion - originates in underreported income receipts and overstated business expenses from the small business sector. It's not surprising then to discover that audit rates for returns that also include Schedule C (sole proprietor business income) are at least twice as high as the rates for individual returns. There are ways that small business proprietors may reduce the likelihood of attracting IRS attention. Here's what professional tax advisors recommend:
  1. Organize all receipts and include notes regarding travel and entertainment expenses (the "who, what, where, when" and a short explanation of the purpose of meeting, etc.). Keep personal and business expenses separate, and remember that IRS auditors are always on the look-out for potential abuse of expense deductions. A small business owner has the right to take every deduction that the law allows, but the IRS has the right to require documented back-up for deductions taken. Good record keeping is essential.

  2. Report all income. The IRS is intent on finding unreported income and small businesses that rely on cash transactions are a frequent target for scrutiny. Agents will look at industry studies and averages to identify filers whose reported income appears suspiciously low. Remember that it is also relatively easy for the IRS to track down and check whether businesses have reported all the income listed on the various 1099s issued to them by their clients.

  3. Operate like a business. It may sound self-evident but it is worth repeating that then IRS will disallow business expenses if it determines that the filer is a hobbyist rather than a business operator. Generally, the IRS gives new start-ups a three-year grace period in which to turn a profit, but it will disallow losses if the enterprise appears to be a hobby. In order to demonstrate a profit motive, a business owner must deploy "usual" business methods - i.e. maintaining financial records, operating a specific business bank account for income and expenses, and having a formal set of books.

  4. Get professional assistance. Frequent changes in tax law make it likely that business owners who prepare their own filings will inadvertently make errors that attract further IRS attention. A carefully prepared return that follows IRS models is much less likely to attract attention. The IRS has more confidence in a professionally prepared return knowing that the books have been reviewed by another pair of eyes and that the tax advisor has their professional reputation on the line.
And finally, if you do receive an audit notice, don't go it alone. A tax professional acts as a buffer between the agent and the taxpayer, and can bring a sense of professional detachment to the interview that can facilitate productive dialog.


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