Internal Revenue Service scrutiny of small-business tax returns is on the rise. The IRS has said that it believes roughly $100 billion of income from small business, home office and other solo-operator sources goes unreported each year.
As a result, the tax-collecting agency has amped up enforcement aimed squarely at small-business returns, including S-corporations, LLCs, partnerships and especially sole proprietors, who generally use a Schedule C to a personal 1040 return to report business-related income.
If there’s “good news” here, it’s this: You can lower your odds of a tax audit by taking certain steps with your tax return, and avoiding others. Each choice you make (how and when to file; what deductions to claim, etc.) has an impact on your audit odds. Here are some things you can do:
• Be accurate, thorough, neat and on time (but not early). Sloppy returns, math errors and rounded numbers raise flags. Using tax preparation software makes your return look more professional and helps avoid mistakes. Filing early only gives the IRS extra time to look it over. Accuracy starts with keeping good records. If the IRS ever questions anything on your return, the burden will be on you to prove it’s right.
• Avoid filing electronically. Sure, electronic tax return filings are convenient, and sometimes required. But the IRS hires temps to enter data from millions of paper returns, and they capture only about 40 percent of the info. Electronic filing gives IRS fast access to 100 percent of your return.
• Explain yourself clearly. Avoid vague expense categories such as the infamous “miscellaneous.” If your business is claiming unusual deductions of some kind, provide an explanation or documentation.
• Send payments when filing extensions. It’s easy to file for an extension if you need more time to get your entire return completed. Just remember that any money you owe is still due by the original filing deadline.
• Beware of your income-to-deduction ratio. Your tax audit odds rise if the difference between expenses and income exceeds about 52 percent. But total deductions are only part of it. One especially large deduction can also raise flags, even if others are small or in line with other businesses in your industry.
• Avoid the independent contractor trap. Another favorite IRS target is misclassified workers. If your business uses freelancers and other independent contractors, make certain they qualify for independent-contractor status or the IRS may claim they are employees and stick you with a big bill for back payroll taxes plus penalties. •
Daniel Kehrer can be reached at editor@business.com.
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