Audits are a potent mix between frightening and rare. The vast majority of filers are never audited, and yet everyone worries about getting mailed an audit notice in lieu of their return.
There are tons of people who think they know what does or does not send up a red flag, but the truth is no one, outside of those connected to the IRS, know what specifically triggers an audit. But we can make some educated guesses based on the data released by accountants and the IRS every year.
For instance, in 2014 only around three percent of all audited returns found an additional refund so chances are good that, if your return is audited, it is not because the IRS believes it owes you money.
The IRS also tends to audit corporations more frequently than individual filers, examining 1.3 percent of corporate returns, compared to only .9 percent of personal returns, meaning a lot of key business deductions are under the microscope.
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Overstating Your Home Office
Until 2013, deducting a home office was an absolute nightmare. The standard method, which you can still opt for, consists of 43-lines of mental arithmetic requiring absolutely meticulous record-keeping. Thankfully there is now a streamlined version of the deduction for up to $1,500, but it remains one of the most well-known red flags for an audit.
52 percent of small businesses are based in people’s homes, so this is a major deduction, just be ready to prove the hours and regularity within which you use that office. I typically recommend some sort of time-keeping tool so you can clock in and out every-day as proving regular use is one of the biggest hurdles.
Paying Yourself Unreasonable Amounts
Corporations may deduct executive pay, effectively making it “tax-free” income at the corporate level. That salary is then typically supplemented with dividends, which are taxed at both the corporate and personal level. So the IRS watches how much of an executive’s pay is “salary,” and how much are in dividends, as over-paying a salary is a well-known way some corporate executives try to skirt the double-taxation issue.
Conversely, because the pass-through structure of an S-Corporation allows income to flow through the company directly to the business owner and, generally, that profit is not subject to payroll taxes, some try to underpay themselves to minimize the total payroll tax withholding.
The IRS thus keeps a close eye on salaries, especially when the corporation is held entirely by one or two people, and recommends that, if setting their own salary, the business’s owner research the incomes of people in comparable positions to ensure there are paying themselves reasonably.
Including Your Commute
This deduction tends to confuse a lot of business owners who mix up when they are, and are not, allowed to deduct expenses related to their commute. Nearly everyone knows you cannot deduct what it costs to get to and from work, but when you run a business the lines delineating your work and personal life blur, and it is much less clear what trips count as going to work, and which do not.
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The same rules apply to business owners as non-business owners in that you cannot deduct “personal” travel. So if you work from home, and go out to meet a client, you can deduct the expenses from that trip, but not from the quick trip to the grocery store on the way home.
Further, if you have no standard office either at home or elsewhere, you cannot just deduct every single trip taken, the IRS actually states that your day’s first and last business contacts outside the home become your “office,” and the cost of getting from your home to the first, and back to your home from the last, are nondeductible. Clearly it can get a bit confusing, so make sure which trips count as your commute, and then meticulously record when you are, and are not, able to deduct your travel.
Not Making Enough Business Income
There are lots of differences between a business and a hobby, but as far as the IRS is concerned, the biggest difference is whether or not you can deduct expenses and losses. The IRS is happy to allow you to deduct business expenses, but does not want to bankroll your hobby. As a result, the IRS keeps a close eye on reported profit and, if your business is not making enough income, it could be re-classified.
A business must make, or eventually make, a profit and, if it is currently costing more to run than it brings in, you have to show that you are running it with the intention of making money. A business that is profitable for at least three of the last five years is normally safe, but that is not a hard and fast rule. It is important, then, that you are able to point to things like a business plan, marketing campaign, and profitability projections to prove you are running a business.
Audits are a pain, but they are not the end of the world. In fact, 71 percent of audits for 2014 were done via correspondence, meaning most of the people being audited just have to answer a few questions and send over their records. Those records are your biggest defense in an audit, though, so make sure you have them.
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Recording every-time you drive to meet a client, rather than to grab a coffee, or sit in your office to answer work e-mails instead of take a personal call may seem like overkill, but the IRS likes hard numbers and these are the deductions filers tend to overestimate. You have every right to deduct your expenses; just make sure you can back up your list with the right records.