Owning a small business can be taxing enough without unduly involving the Internal Revenue Service, so take care to avoid small-business audits. Small-business owners, especially sole proprietors, are at special risk of being audited, because the IRS believes self-employment incomes are grossly underreported, experts say. The agency increased its number of small-corporation audits by 145 percent from 2004 to 2005, and in 2006 issued a report in which it estimated that unpaid taxes topped $345 billion in 2001, with about 32 percent stemming from underreported business income.
While tax professionals say it is unlikely the IRS will come knocking at your door, "if you're the one, it's not a good place to be," says Barbara Weltman, author of Small Business Taxes 2007. After all, audits cost time and money - two things most small-business owners have in short supply.
To help your small business avoid an audit or weather one if it comes, employ the following strategies.
File Complete FormsThe IRS is forced to take a second look if you leave parts of your schedules or returns blank. Double-check to make sure your documents are complete before submitting them. And don't forget to sign the forms.
Report All IncomeThe government is particularly interested in whether the self-employed report their full income, so be sure to properly list all earnings. Use the exact figures that appear on your 1099 or W-2 forms. "If you don't, the IRS computers are going to know it," Weltman warns. The IRS has also been on the alert for errors in Schedules K-1, the form used to report incomes from partnerships, S corporations and some trusts on individual tax forms. The government is more likely to investigate cash-based businesses, so make sure your accounting is tight if you own a restaurant, for example. Cash transactions of more than $10,000 need to be listed on Form 8300.
Keep Accounting ConsistentMost small businesses with sales of under $5 million can choose one of two accounting methods: cash or accrual. The cash method reports income in the tax year it's received, while expenses are deducted in the tax year they are paid. You may be required to use the accrual method if you produce, sell or purchase merchandise. This method requires income be reported in the tax year it is earned and expenses deducted in the tax year they are incurred. You need to first receive IRS approval if you change your accounting method. Switching accounting guidelines on your own or mixing the two nearly guarantees the IRS will take a hard look at your returns.
Tiare Rath is a freelance journalist and a former personal finance columnist for MarketWatch.com.