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Tax advice: How to lower your audit odds

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Saturday, April 01, 2006

Odds are slim that the IRS will audit your business taxes. If you’re honest and keep good records, there’s not much to worry about. That’s the good news.

Now the bad: Audits are up. Way up. And who is most likely to be audited? Sole proprietors — the most prevalent type of small-business ownership. All those deductions your business is legally allowed to take can also trigger IRS flags. Sole proprietors are at least 10 times more likely to be audited than other business entities.

But wait. There’s more good news.

The IRS lacks enough people-power to scrutinize every tax return, or anything close to it. So they target those they believe will yield the most payback in taxes and penalties. That means there are concrete steps you can take that will lower (though not eliminate) your chances of an audit.

The reason is something called a DIF score — gov-speak for Discriminate Information Function. This is the secret IRS formula that decides if you’ll be audited or not. And while the details of DIF (and UI-DIF, which sniffs for unreported income) are hush-hush, these simple steps can help you avoid the audit hook:

  1. Be accurate, thorough, neat and on time (but not early). Sloppy returns, math errors and rounded numbers raise flags. Using tax preparation software is a great way to make your return look professional. And the software helps you avoid mistakes. File on time, but filing early only gives the IRS more time.
  2. Do not file electronically. The IRS hires temps to enter data from millions of paper returns, who absorb only about 40% of the information. Electronic filing gives the IRS easy access to 100% of your return.
  3. Be honest. Every year, the IRS gets better at using technology to track down your business income. And some things are just obvious. If you claim lots of expenses, but show little revenue to pay for them, the tax folks get curious.
  4. Explain yourself. Avoid vague expense categories, such as  “miscellaneous.” And if your business is claiming unusual deductions, provide some explanation or documentation.
  5. Make your quarterly tax payments. It is vital to make them on time and to not underpay. Late payments, non-payments and underestimated amounts draw IRS attention.
  6. Beware your income-to-deduction ratio. You are more likely to be audited if the difference between your expenses and income exceeds 52%. Watch out for abnormally large deductions. It’s not just the total amount of deductions that’s important. A single large deduction can also increase your audit chances.
  7. Form a corporation or other business entity. To avoid the higher risk of sole proprietor audits, consider making your business a corporation or limited liability company (LLC).
  8. Hire a tax pro. If your return is complex or you are uncertain about treatment of deductions, income or other areas, don’t hesitate to bring in a CPA or other business tax pro. The money will be well spent.
  9. Beware the home office deduction. It’s a prime IRS target, so if you plan to use it, make sure you know the rules. IRS Publication 587, Business Use of Your Home, can help.
  10. Sign it! Simple, but so often forgotten. And all it does is call attention to your return.
— Daniel Kehrer, BizBest Media
  • If your business issues 1099 forms, W-2s, 941s or related forms, a terrific place to do it fast is Filetaxes.com. Open an account and have your forms out in minutes.

  • CCH Tax & Accounting is a top supplier of tax information and software to small business. Their CCH Business Owner’s Toolkit is an excellent resource. Visit www.toolkit.cch.com.

  • TurboTax is a popular line of tax preparation software from Intuit (which also makes Quicken). Visit www.turbotax.com.

  • To download IRS Publication 587, Business Use of Your Home, or other IRS publications, go to www.irs.gov/publications. The IRS small business website is easy to navigate and covers every tax topic you can think of. Visit www.irs.gov/smallbiz.

  • A tax professional can help you face an audit. CPAdirectory.com lists 450,000 CPAs nationwide. Searchable database helps locate CPAs by name, location, specialization and industries served.


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