Beware of the Taxman: What Small Businesses and the Self-Employed Can Do To Avoid An IRS Audit

Watch out. The Internal Revenue Service reported early this year that IRS audits were up. Frankly, it's not real surprising. It's during hard times that taxpayers feel the pinch and are more likely to cut corners. Likewise, as tax revenue goes down, the government will look for more income by increasing audits, publicizing that fact, and in that way frighten more taxpayers into complying.

Law firms specializing in financial matters expect to have more than the usual number of cases in the near future as more unlucky taxpayers get caught in the taxman's web.

Here are tips to avoid an audit, especially for self-employed individuals and business owners, who tend to be favorite enforcement targets for IRS:

1. Be scrupulously honest. Report all income, even when you don't get a 1099 or W-2. Deposit all cash, religiously, into the business account. Don't take cash, bypass depositing it into an account, and use it to pay expenses. If the agent sees a lot of this, it'll make the case easier for unreported income. Remember: The burden of proof is on the taxpayer. Ignorance and sloppiness are not an adequate defense. Regarding deductions, don't try to reach. Always ask yourself: Is this a defensible position? Is the deduction proper? Here's an expression one hears often: "Pigs get fat, hogs get slaughtered." I'm told it was first uttered by a judge -- in a tax case.

2. Speaking of deductions, beware of "constructive dividends." This is a favorite of the IRS. Small business owners often use the corporate account to pay for personal goods or services, such a car used for the personal errands of the owner, non-business meals, vacations, home improvements, and so on. IRS and the state tax agents know it, and look for it. If it's personal, report it in your personal income tax return or reimburse the company and make sure to give it only the correct tax treatment as compensation, or dividend, in consultation with your accountant. This is often one of the charges in a tax criminal case.

3. Use a reputable tax preparer. Tax is very complicated. Furthermore, the law changes every year. The person preparing your return should have credentials (education and experience). Mistakes, including math errors, in one part of the tax return increase the odds that the whole return will be audited. Don't pick someone because they promise to get you the biggest refund or the lowest tax bill. That's a red flag signaling a fraudster. You don't want to be questioned by the IRS when they investigate this scammer's entire client list.

4. Keep good records. Of course this is something you should have done throughout the year, but you can still heed this advice for the coming year. Keep your receipts, especially for expenses you deduct. You will be asked for them on audit. Remember: To deduct actual mileage you must keep a log at the time of the event i.e. at the time of the trip, not a reconstruction weeks afterward. At the same time, you want to have invoices for all payments you make. (Otherwise, on audit, how do you prove the deduction you took for office supplies wasn't just money you pocketed? Bring the bills marked "paid" from your vendors.) Meticulously deposit all your income into an account and pay your bills out of that account or designated credit cards. If you're self-employed, or have a side-line business in addition to your employment, do NOT commingle income and expenses of your business with your personal. Keep and use separate accounts, ATM cards, and credit cards for your personal transactions and your business transactions. The lack of good record-keeping is one of the biggest problems we face as tax practitioners working with small businesses. Just keeping "books" makes such a difference for business planning and profits, as well as defending an IRS audit.

5. Keep regular books if you have a business. It's good business practice, too, to keep books during the year. Often the problem arises because the taxpayer does not pay in during the year, or does not set aside, and then does not have the money to pay at the end of the year. Had they paid taxes during the year, this problem would have been avoided. From a business point of view, they would also had a better idea of profitability had they taken into account tax "accrual" expenses building up during the year. So many contractors under-bid because they don't take taxes into account, and end up subsidizing the buyer with the tax liability they will later face!

Finally, if you do run afoul of the IRS or state tax authority, seek competent and experienced counsel, preferably from a professsional with a state-issued license and with whom you meet personally. Avoid the hucksters promoting settlement of your tax debt for "pennies on the dollar" -- schemes that mostly don't work as advertised.


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Edward Gonzalez specializes in bankruptcy and tax law for individuals and small business in MD, VA and DC. He worked for the IRS and has more than twenty years experience. For more information, call the Law Office of Edward Gonzalez, P.C. at (202) 822-4970 and visit his website at http://www.money-law.com/