What’s more dreaded than paying taxes? An IRS audit.
Small business owners are particularly at risk for audits, which can be expensive and time consuming. Fortunately, audits are less painful that they once were since the IRS usually requests clarification of items on your return instead of doing a full audit.
Still, some taxpayers invite a more thorough look from Uncle Sam by throwing up red flags on their returns. To avoid an audit, you need to know what the IRS looks for. Most audits can be avoided before they begin.
To audit or not to audit?
The IRS uses a two-step process to decide which tax returns to audit.
The first step applies a mathematical analysis known as the DIF, or Discriminate Index Function system. This compares the taxpayer’s deductions to norms for their income, taking into account variables such as occupation, family size, zip code, and tax history. This process creates a three-digit score. Like golf, you want a low score.
The second step involves a person reviewing selected returns to decide whether they really justify the time and expense of an audit. The reviewer is authorized to override a high DIF score if there is a reasonable explanation for high deductions or low income.
Common red flags and how to prevent them
The two biggest red flags for the IRS are incorrect reporting and claiming a large or unusual deduction without an explanation.
- Incorrect reporting. Doing your own taxes may increase the likelihood that you’ll be audited. The IRS knows a self-prepared return is more likely to contain errors than one prepared by a professional. The screener also knows that what is claimed on a return done by a professional has probably been reviewed and is supported by documents and complies with legal requirements. If your return received a high DIF score because of one or two unusual items, the fact it is prepared by a CPA or other professional may be enough to override the DIF score. Using a CPA to prepare your taxes helps avoid errors and prevents you from including things on your tax return that might attract attention at the IRS.
- Unusual deductions. Unusual deductions include expenses that are out of the ordinary, such as large business expenses, large charitable donations, or substantial medical expenses. You should claim them, but help the reviewer understand their validity. Attach an explanation for the high business expenses. Include receipts for some of the larger medical expenses. Enclose a statement from the charity about your large donations.
For example, a client who started a business lost so much money the first year that it was impossible by looking at his tax return to see how he supported himself. His income was so low that a reviewer would have wondered whether his business was really a hobby or if there was other income he wasn’t reporting. He avoided a closer look from the IRS by attaching a note explaining that the business was profitable the next year and that he borrowed money against his house to finance the start up expenses.
Another client made a charitable donation of thousands of dollars worth of property he received from his parents’ estate. This is permissible; you can take a deduction for property given to you and property you inherit if you donate it or if you use it in your business. Since the amount was so large, we prepared an itemized list of what was donated and to whom, explaining that it came from his parents’ estate.
The likelihood of being audited increases with the size and complexity of your financial affairs. The deductions are larger, the reporting requirements are more complex, and there’s more at stake at your business grows. You don’t want to find out down the road that you’ve been claiming things incorrectly, or missing opportunities for several years. Protect yourself from the beginning by working with a tax professional.
Lee Marsden is an attorney with the law firm of Gullett, Sanford, Robinson & Martin. A 1988 graduate of Vanderbilt law school, he also practiced as a CPA in California and Tennessee from 1979 to 1993. |
Reduce Your Chances of Being Audited