What are the chances that your business will be audited by the IRS? Well, if you own a business with Schedule C gross receipt over $100,000, the odds are about 2.3%. Audit rates for S corporations and partnership LLCs are only about 0.4%.

According to the Wall Street Journal, Self-employed entrepreneurs are 10 times more likely to get audited if they file a Schedule C rather than those who file a corporate return. The reason for this extra scrutiny of Schedule C filers may be found in a study by the U. S. Government Accountability Office where it was estimated that 70 percent of the sole proprietor tax returns reporting in 2001 had, ”losses that were either fully or partially noncompliant.” This means that 7 out of 10 self-employed business owners took business write-offs where they shouldn’t have.

While it is true the IRS on occasion will randomly pull a tax return for audit purposes (otherwise known as the audit lottery), auditors are more likely to reach for the low hanging fruit and select a return for audit because of some anomaly or “red flag” that the taxpayer has waved in the auditor’s face. There are some definite items on a tax return that will snag an IRS agent’s attention. So what are some ways a business owner can take down some of these “red flags”?

First, if you are a Shareholder-employee, pay yourself a reasonable salary. The IRS does not appreciate C corporation business owners paying themselves large salaries to keep from paying corporate taxes on the same money. By the same token, the IRS frowns on S corporation employee-owners paying themselves very little so they can take large distributions at a lower tax rate. Both of these situations may catch the eye of the IRS and that is not good. The point is, pay yourself what you would pay an unrelated third party to do the same job.

Having a large number of independent contractors compared to employees can also catch the attention of the IRS. This might be interpreted as an attempt by you, the owner, to avoid paying payroll taxes. The IRS has strict guidelines on what constitutes an employee and what is considered contract labor. Read the regulations thoroughly and apply them to your situation or ask an accounting firm for guidance. Simply having a contract and calling someone an independent contractor does not make them one in the eyes of the IRS. If it is necessary for you to use independent contractors, make sure you keep good records, issue 1099-Ms to each contractor and make sure the information on the 1099’s are complete and accurate.

Report every dollar you make. Remember, when you get paid by a client or customer, the chances are pretty good that some or all of that money will be reported as an expense on someone else’s tax return. The customer may go as far as issuing a 1099-M for your service. The quickest way to an audit is for you to report income that is less than what others have reported for you.

Don’t guess at deductions. This is where recordkeeping is so important. It may be easy for you to give a “ballpark” figure how much you spent on gas for your lawn service but your best guess will not hold up in an audit. Even if you pay by check, receipts usually have more information on them and simply because you know how much you spent and where you spent it, does not mean you will remember what you bought. Though keeping records may not prevent an audit, good records can drastically shorten the time the audit takes and certainly helps with the outcome.

If your business has been losing money for a few years, the IRS may step in and make sure that what you call a business isn’t just a hobby. The IRS believes the intent of all business is to make a profit and your business is no different. If you do experience losses for more than two or three years, make sure you keep good records. Especially records as to how you have been able to operate your business at a loss.

Some other items the IRS may look at are large charitable contributions and travel expenses. Any charitable contribution over $250 must be substantiated with a receipt and those over $500 require that a form 8283 be filed with your tax return. Large travel, meal, entertainment, and vehicle expenses may be flagged as well. Once again, keep good records.

Even though the chances of being audited by the IRS may seem slight, there is no reason to make things easy for them. The more unattractive you can make your business to the auditors, the better. So take down all those red flags and sleep a little better at night.

For more information about audit red flags, talk to Abacus CPAs. Contact us today at 417-823-7171 or visit our website www.abacuscpas.com! Better Guidance. Smarter Decisions.

Ron Hill