What can you do now to minimize the likelihood that you'll come under IRS scrutiny? While there are no guarantees, there are some actions that may be very helpful in this regard.
1. Know the tax rules
As the old saying goes, the best defense is a good offense. Knowing the tax rules and following them will go a long way toward keeping you safe from an audit. At the very least, having a reasonable belief that you are following tax rules can help to avoid tax penalties if it turns out that you are audited and found to be in the wrong.
2. Keep good records
While this won't prevent an audit, it may avoid escalation into a broader examination by the IRS. Say the IRS sends a letter (which is a correspondence audit) asking for proof for a specific deduction. With good records, you can substantiate positions taken on the return if the IRS raises questions. Without the proof, the IRS may raise additional questions.
3. Use IRS programs
If you prefer to take a conservative approach, you can rely on certain IRS programs to protect yourself for specific matters.
- Use the Voluntary Classification Settlement Program (VCSP) to reclassify workers as employees. This will protect you against audit on this matter for previous years.
- Use IRS tip programs. With these voluntary education programs, employers (such as those in the restaurant industry or the gaming industry) educate employees about tip reporting; the IRS will refrain from auditing employers participating in these programs with respect to tip withholding.
4. Don't take certain write-offs
Certain deductions and credits may attract the attention of the IRS more than others. Some write-offs have been labeled audit red flags for business owners, so waiving or modifying write-offs may make sense:
- Don't take a home office deduction. Some tax experts believe this deduction is an audit red flag. I don't agree. Nonetheless, the deduction may not be significant, so those who want to err on the safe side, especially if there is a question about eligibility for the deduction, may want to forego it.
- Don't claim 100% business use of a vehicle. While a van or truck used exclusively for business may merit the 100%-business-use claim, a passenger vehicle available for personal driving is suspect, especially if the owner has no other vehicle available for personal driving.
- Don't claim T&E deductions for personal expenses. Most small businesses have deductions for travel, meals, and entertainment costs. But don't use this write-off for wining and dining a spouse, relatives, and friends when there is no business reason. Don't deduct your lunches in town unless you are treating a customer, client, or other business associate.
- Don't claim higher-than-average deductions. While the IRS doesn't publish what "average deductions" mean for particular businesses, a number of years ago the Government Accountability Office (GAO) reported data on sole proprietors. While the dollar amounts of deductions may no longer be relevant, they do indicate the portion of deductions to income that may still be useful today.
5. Don't invite an audit
You are virtually guaranteed that your return will be examined if you take certain actions. In most cases, it's advisable not to file the following forms:
- Form 5213, Election to Postpone Determination as to Whether the Presumption Applies that an Activity Is Engaged in for Profit. This form asks the IRS not to audit a new business until the expiration of a set period (generally five years). It allows a new business to demonstrate having a profit motive (and not being a hobby activity) by showing a profit in three of five years (two out of seven years for certain horse-related activities). Instead of filing the form, operate the activity in a businesslike manner in order to demonstrate your profit motive. Then, if you are audited, you can muster factors to support your profit motive.
- Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR). Partners and S corporation shareholders can, in some cases, choose to report business items on their personal returns in a way that differs from the entity's reporting of the items on Schedule K-1. In most cases, don't. Instead, report business items as they appear on the Schedule K-1.
6. Incorporate your sole proprietorship
Audit statistics show that sole proprietors are much more likely to be audited than partnerships or corporations (S or C). For example, in the government's fiscal year 2011, sole proprietors with gross receipts of $100,000 to under $200,000 have an audit rate of 4.3% ($200,000 or more, 3.8%). In comparison, the audit rate for all partnerships and S corporations was 0.4%.
Forming a limited liability company (LLC) with a single owner may not help with audit risk. The LLC files the same Schedule C of Form 104 as a sole proprietor.
7. Work with a good tax advisor
Taxes for business owners today are very complex, taking into account not only income taxes, but also employment taxes, excise taxes for certain businesses, and state tax issues. The best strategy for minimizing the chances that you'll be audited is to use a good tax advisor. Seek a referral from someone you know (e.g., your banker, your attorney, or another business owner). If you don't know anyone, check your state's CPA society for a referral.
Steer clear of any tax advisor that makes promises that sound too good to be true. If you're guaranteed that you will get a refund or that you don't need to show any documentation, this is a sign that the tax advisor is shady. Once an advisor comes under IRS scrutiny, his or her clients will likely be examined. And the IRS is cracking down on preparers who have taken questionable positions on clients' returns.
While you can't bullet-proof yourself against an IRS audit, you can reduce your chances of examination, or at least improve your chances of success if you are audited.