NFIB

Avoid Audits
02/ 03/ 2003

by Alan Breznick

If there's one phrase that sends chills up the spines of small business owners, it's "tax audit." Even though the Internal Revenue Service audits relatively few companies, each year millions of entrepreneurs cringe at the prospect of getting nailed.

What's the best way to avoid an audit of your company's tax return? Be lucky, tax experts say.

Luck not withstanding, there are steps that small business owners can take to reduce their audit risk. For one thing, they can incorporate their firms, no matter how small. Over the past few years, the experts say, S corporations and limited liability corporations (LLCs) have been audited far less frequently than sole proprietorships.

Chuck Weinberg, who runs an accounting firm in Rockville, Md., advises his small business clients to incorporate their businesses, noting that sole proprietorships are audited more often, statistically. "Being a sole proprietor is going to get you audited far faster than an S corp," Weinberg says.

Government statistics bear this out. In one set of data released in 1999, the IRS revealed that it audits as much as 4.21 percent of sole proprietorships, as opposed to just 0.92 percent of S corps and a mere 0.49 percent of partnerships (including LLCs). More recently, the IRS disclosed that it audits only one in 400 partnerships.

IRS officials also warn entrepreneurs against misclassifying their employees as consultants. Some small firms have been increasingly filing false tax returns and W-4 forms for salaried workers, calling them independent contractors to avoid payroll taxes. Alarmed by this trend, the IRS said last fall that it will step up its efforts to combat such scams this year.

"It's the No. 1 audit trigger," says Roger Russell, tax editor of Accounting Today, a New York-based trade magazine. If found guilty, he says, "you end up being liable for back employee taxes, penalties and interest."

Tax experts also advise small companies to carefully document high travel, entertainment, medical and other business-related expenses, since claiming a significant amount of expenses can raise red flags with the IRS.

Business owners who claim a home office deduction already know the process is complicated. Fear of audit has led some small business owners to avoid taking a deduction to which they are legally entitled.

Finally, the experts urge entrepreneurs to report and account for all income. In September, the IRS, facing a huge surge in unreported income, came out with a new tool for targeting tax returns with suspicious income figures.

"Unreported income will trigger an audit very easily," says Shirley Chu, who has an accounting practice in Raleigh, N.C.

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This article originally appeared in the February/March 2003 issue of MyBusiness magazine.

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