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Top Ways to Avoid Small Business Audits

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Audit Stamp on Tax Form
Jeffrey Coolidge/ Photodisc/ Getty Images

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.

Keep Excellent Records

Tax time is easier when you have records detailing income, expenses, debts and deductions. This professionalism will show on your returns. Less than 4 percent of sole proprietors are audited, according to Weltman, and the IRS questions only 2 percent of Americans about their tax returns, the National Federation of Independent Businesses reports. Still, the NFIB advises keeping records and receipts for at least seven years.

File Complete Forms

The 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 Income

The 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 Consistent

Most 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.

Accurately Assess Independent Contractors vs. Employees

The National Society of Accountants warns that the IRS is on the lookout for business owners who qualify employees as independent contractors. If you tell your freelancers when and where to work and don't use contracts, for example, the government might consider the workers employees and expect you to pay payroll taxes. Also, remember that 1099s are required for contractors who made $600 or more during the tax year.

Watch Professional/Personal Deductions

The IRS is strict about not mixing the personal and the professional when it comes to write-offs. To qualify for a home-office deduction, your kitchen table can't double as your desk, Weltman says. She advises taking a photograph of your workspace for tax purposes. You and your employees can use personal vehicles for business, but record when, where and why you used them, as well as the exact mileage. And it's fine to take the family to Florida while you attend a conference, but only your business expenses are deductible and must be recorded accurately.

Consider Getting Help

Depending on how complex your taxes are, you may want to seek help in filing taxes for your small business. If you don't think you need a professional, Weltman advises using tax software. By using tax-advice resources, you'll have a better chance of submitting returns that won't raise red flags -- thus avoiding an audit.

Tiare Rath is a freelance journalist and a former personal finance columnist for MarketWatch.com.

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