Avoid That Dreaded Letter from the IRS
6 ways to lower the chances of an audit of your business tax return
Business owners dread getting an audit notice from the IRS. It causes immense stress that investigators will find something that results in you having to pay a penalty – or worse. However, are you aware of the things you can do to help avoid an audit in the first place?
Here are 6 tips you can use to help audit-proof your business tax return
1. Lower your DIF score
The IRS selects tax returns for audit based on a computerized scoring system called the Discriminant Index Function (DIF). This system assigns a score to individual and corporate tax returns.
“[F]ormulas are developed … to classify returns by assigning weights to certain basic return characteristics. These weights are added together to obtain a composite score for each return processed. This score is used to rank the returns … highest to lowest,” according to the IRS.
If you receive a high score on your return, there is a much better chance that the IRS will choose to audit you.
Items and deductions that can result in a higher DIF score may include:
- Income other than basic wages, such as contract payments
- Unreported income, such as investments
- Home-based business or high home-office deductions
- Noncash charitable donations
- Large business meals, entertainment, or travel deductions
- Excessive business auto usage
- Losses from an activity that could be viewed as a hobby rather than a business
- Large casualty losses
- Claiming deductions on personal returns rather than through the business entity
Any tax return that is flagged by the DIF system goes through a manual screening for further evaluation. If the IRS determines there is a cause, you may become subject to an audit.
2. Avoid writing off too many deductions on your personal tax return
A lot of business owners make the mistake of writing off too many things on their personal returns rather than the business entity’s return. This can result in a high DIF score, as the relative weight of a scored deduction on a personal return is higher.
You can lower your score by having deductions flow through from the business entity to your personal return as one number.
3. Cross check all numbers on tax forms
If a vendor or client issues you a tax form (such as 1099), they will also file that form with the IRS. You must be sure that you report the correct amount on your business taxes.
The IRS may screen the figures on your return to make sure they sync up to the returns they get from other parties. Any discrepancy can result in a notice to correct the return – or an audit.
4. Be careful when reporting business losses
If a net loss is reported on your businesses taxes for too many years, it can lead to a higher score. The IRS may decide to label your business a “hobby,” meaning you won’t be able to claim business deductions for that activity. To learn more about the “Hobby Loss Rules” and how to navigate them, check out our recent blog.
5. Be aware that what you pay certain employees, and the type of employees can raise your score
C corporations that pay an unusually high salary to executives can result in a higher DIF score, as this is a common tactic used to minimize profits and lower taxes. Make sure you don’t exceed a reasonable salary range for your industry to avoid triggering an audit.
Another red flag can be having a high ratio of “independent contractors” versus employees. Using independent contractors allows a business to avoid payroll taxes and other benefits that must be paid to full-time or eligible employees.
6. Have thorough documentation for all of your deductions
This may be the most important thing you can do, especially if you ever do get audited. Be sure to keep careful, accurate records regarding all of your income as well as documentation to back up any expenses or deductions that you claim on your taxes.
Receipts, payment slips, canceled checks, and any tax forms from vendors or customers are some essential components. Anything that provides specific, verified information can help; for example, auto expenses can be backed up using Google maps to prove an estimate of miles.
You must provide enough detail to explain deductions rather than simply file them as “miscellaneous” expenses. You also want to collect and save this supporting documentation in case you ever do get audited.
Remember, the key to surviving an audit is “documentation, documentation, documentation.”
The way you structure business taxes and claim deductions can result in a higher score from the IRS, which may result in a dreaded audit. Follow these 6 tips to help lower your score.
Our bonus tip is to consult with a tax professional who is trained to protect your assets and minimize your tax burden. Contact Provident CPA & Business Advisors today at 855.693.7829 or [email protected] for all of your business tax needs.