Uncle Sam Wants Small Businesses

Small business audits are on the rise: How to survive the IRS

As you close the books on 2006 and start thinking about preparing your federal tax return, keep this in mind: The Internal Revenue Service has stepped up audits of small businesses to help close the estimated $290 billion “net tax gap” – the amount by which businesses and individuals underpay their taxes, not including interest and penalties.

In other words, be very careful, because the IRS is more likely than ever to question your return. Audits of S corporations, considered the cornerstone of the small business economy, jumped by 35% from 10,147 in fiscal 2005 to 13,984 in fiscal 2006, and audits of partnerships rose by 15%, from 8,489 last year to 9,777 in 2006. Audits of small businesses organized as C corporations inched up from 17,858 in fiscal 2005 to 17,871.

If you run an S corporation or partnership, you should be a little paranoid. “We have found an increasing use of them to improperly avoid taxation,” IRS spokeswoman Lea Crusberg says. That’s because S corporations and partnerships are pass-through entities, meaning the business pays no corporate income tax, but the partners or shareholders do pay income tax. As a result, the IRS knows, it can be exceedingly tempting for business owners to have the company pick up the costs of vacations or new cars that can be made to look like legitimate (and, therefore, tax-free) corporate expenses.

Even if you are an absolute Boy Scout about your corporate expenses, you still can be caught in the small-business dragnet. That dragnet, according to a U.S. Small Business Administration study, costs on average of $1,304 per employee for a business with fewer than 20 workers. For companies employing 20 to 499, the 2005 study found the cost dropped to $948 per employee and to $780 for a business with at least 500 employees.

To improve your chances of avoiding an audit and making the best of a bad situation if the IRS questions your return, here are some handy tips:

• Consider incorporating your business. “From a tax standpoint, it’s a no-brainer. The IRS has found ways to audit sole proprietors and find more things wrong,” says Cleve Gazaway, a CPA in Houston who’s a member of the National Association of Small Business Accountants. Sole proprietors are several times more likely to be audited than incorporated businesses, experts say. If your business grosses more than $100,000 a year, consider incorporation, says Norbert Gonzales, a CPA and attorney in San Antonio who’s also a member of the NASBA.

• Install software to track your business’ finances, such as Intuit Inc.’s QuickBooks, Microsoft Corp.’s Money or Sage Software Inc.’s Peachtree. Two-thirds of Gazaway’s clients use QuickBooks, which he says is “cheap and easy to use.”

• Keep all receipts and other documents connected with business expenses, particularly travel and entertainment receipts. Use a company check, a debit card or a credit card to gas up the company vehicle or pick up office supplies. By doing so, you establish an electronic log of business expenses, Gazaway says. “People who walk around and pay for things with cash are the people who lose the deductions,” he says. “All of that adds up at the end of the year.”

• Scrupulously separate business and personal expenses. If you don’t, “it opens the door for the IRS to question everything once they start seeing that,” Gazaway says. If you can’t live without a Rolex, borrow the money from your company to buy it or pay yourself a salary to cover such purchases, he says, but don’t dip into your business accounts.

• Don’t fill out your business return by hand. “It’s better to do it by computer,” says Macey Davis, tax counsel for the National Federation of Independent Business. “For some reason, the IRS tends to give handwritten returns closer scrutiny,” she says. “If it’s sloppy and confusing, then they’re definitely going to have difficulty reading a return and that could really raise a red flag.”

• Use exact numbers when tabulating deductions on your tax return. If you round the numbers, the IRS tends to assume you’re just estimating, Davis says.

• It sounds elementary, but double-check the math on your return. “While the IRS may automatically correct some errors, if a return is full of math errors, it’s definitely going to be red-flagged,” Davis says.

If you’re tapped for an audit, don’t panic and don’t automatically assume you’ve done something wrong. Oftentimes, businesses are selected randomly for audits, Davis says. Contact your tax adviser right away or hire one. The IRS says having a reputable tax preparer can greatly reduce a business owner’s chances of running into tax trouble.

When you are notified of an audit, be responsive and prompt. “If it is a situation where you do, in fact, owe more taxes than you’ve paid, you don’t want to be running up the interest charges and late fees any more than necessary,” Davis says.

If you’ve followed the suggestions above and you have well-organized documentation, the tab for having an accountant help you prepare for the audit may be $600 to $1,000. If your records are in disarray and an accountant must retrace your financial steps, the bill could be $6,000 to $10,000, Gonzales says. The IRS conducts audits by mail, or through a review of tax records and an interview at an IRS office, a taxpayer’s business, a taxpayer’s home or an accountant’s office.

“You want to make it just as efficient and simple for the auditor as possible to get in, look at the stuff and get out,” Gonzales says. “You don’t want the auditor dilly-dallying around.”

Don’t share more information than is necessary: If the auditor asks for vehicle expenses, hand over only vehicle records. Turning over your entire general ledger could prompt an IRS “fishing expedition,” Gonzales warns.

“I think it’s a terrible mistake to go into an audit with an open book – a trusting soul walking into a situation where you really can get hurt,” Gonzales says. “Never, ever give an auditor carte blanche to all your records.”