How Small Businesses Can Audit-Proof Their Tax Returns

There are differing degrees and levels of audits, yet they all have one thing in common: They are triggered by what people put in their business tax returns. The IRS has something called “discriminate function” programmed into their computers, and when the numbers on a return fall under certain criteria, the return is flagged for manual review. An agent then will determine if that return should be audited.

Although the specific criteria are secret, we do know that certain things will trigger audits—including ratios and unusually high deductions, and certain tax shelters and strategies. The following is a list of audit triggers on corporate, partnership and other business returns that you can easily avoid.

Don’t Round Numbers: Deductions rounded off to the nearest hundred or thousand will lead the IRS to think the taxpayer is guessing rather than determining from accurate records. (You didn’t spend $10,000 on advertising—it was $9,487.56!)

Answer All Questions & Fill In All Boxes: Blank doesn’t mean “no.” Questions on various returns involving trusts, partnerships, foreign accounts, accounting methods, etc., should be answered. Don’t leave them blank.

Categorize Deductions: Large deductions headed “Miscellaneous” or with vague wording may lead the IRS to decide you’re not keeping good records, can’t prove the deduction or are hiding false deductions within that general category.

Be Careful About Distributions: Distributions taken on Schedule K of your corporation tax returns (1120 or 1120S) have special guidelines that must be followed. If you are a sole shareholder of a “sub S,” a recent tax court ruling holds that you may not take distributions; instead, they must be structured as payroll. If there are multiple owners, the amount of distributions on Schedule K must always be less than officers’ compensation on page one of your 1120S. If you are a “C” corporation, most distributions will be considered a dividend and subject to double taxation.

Document NOLs (Net Operating Loss) Very Carefully: If you have a year in which large losses in your business occur, you may go back three years by filing for NOL and receive refunds of taxes paid previously. NOLs are scrutinized very carefully and audited most of the time. Be sure your documentation is near perfect before filing.

Beware Of Skewed Ratios & Constant Business Losses: These are immediate red flags on your file. For example, a real estate office may have gross commissions of $200,000 in one year and expenses of $190,000. A couple of years later, the gross income rises to $600,000. Will the expenses also rise to $570,000? Probably not. (Note: That was an actual case that was audited. As you may guess, the results weren’t very good.)

Choose Your Tax-Preparer & Accountant Carefully: You are responsible for your business return. If there are errors triggering an examination, you are the one who will be audited and forced to pay. In addition, when the IRS suspects tax preparers of incompetence or misconduct, it can force them to produce lists of clients who may face examination. Use the following guidelines when choosing an accountant or tax-preparer:

• Always use preparers with certifications. EAs (Enrolled Agents), CPAs and attorneys are the only people authorized by the Treasury Department to represent clients before the IRS. There are many good preparers out there without certification, but how would you know who is good versus who is not?
• Never accept a return without the preparer’s tax ID number and signature. Tshis is required by law. If it is left blank or states “Self Prepared” there’s something wrong!
• Review your return. Are the figures on the return the ones you gave? Ask questions. Even the best preparers can make a mistake, especially during the pressures of a busy tax season.
• Talk to your accountant. Be sure you’re on the same page and ask about strategies. Be proactive. It will keep you out of trouble and save you money.

In recent years IRS audits have dropped for staffing reasons, but now they are increasing. Businesses and average-to-higher income individuals have greater chances for audits in coming years, so take steps to prevent it from happening to you.

Patrick Astre CFP, EA, RFC is an author, speaker and recognized tax and financial expert specializing in the economic issues of longevity and business. As the founder of Astre Planning, Inc., Astre has been advising individuals, small businesses and corporations for nearly 40 years. He is the author of, "This is Not Your Parents' Retirement," and "Educated Investing and the Four Seasons of Money." For more information, call (631) 744-9100 or visit http://www.prosperousboomer.com/.