Small moves could trigger IRS audits

Special to The Times

Waving a red flag under the nose of the Internal Revenue Service is not the goal of most small-business owners, yet many do so without knowing it when they fill out their tax returns.

A simple math error, a claim of sustained losses, even the corporate structure of a business may mean increased scrutiny. With audits on the rise, it’s more important than ever for a small-business owner to avoid mistakes and to be prepared to back up legitimate claims.

“There is a lottery aspect to it, but it’s not one I’d be willing to play,” said Philip Strauss, a tax partner in the Los Angeles office of BDO Seidman.

After years of decline, audits are rebounding as the IRS, pushed by Congress to close the estimated $345-billion “tax gap” between what Americans owe and pay, searches for unreported income and inflated expenses.


Audits of individuals, which include sole proprietors who file the Schedule C form with their tax return, jumped 74% over the last five years to 1.3 million in the fiscal year ended Sept. 30. Sole proprietorship audits are estimated to be two to three times the rate for individuals who don’t file a Schedule C.

The California Franchise Tax Board, which collects personal income and corporate taxes for the state, also has ramped up audits, tax experts said.

Both agencies are targeting so-called S corporations. These are companies that pass profits, untaxed, on to shareholders where, under subchapter S of the Internal Revenue Code, the profits are taxed on shareholders’ individual returns.

Shareholders thus avoid the double-taxation of paying a corporate level tax on profits and then an individual income tax when they receive them.


IRS audits of S corporations jumped 34% last year to almost 14,000, even as the total number of S corporation returns grew just 5% to 3.7 million.

No matter what the size or structure of your business, it makes sense to avoid as many audit triggers as possible. IRS enforcement actions, including levies, liens and seizures, were up 34% in fiscal 2006, compared with 2005.

The easiest step is to make sure your return is filled out completely and accurately -- no missing numbers, no math errors. That can help prevent the return from being kicked out of the automated process to be checked by an IRS employee.

Many small-business owners rely on a professional tax preparer or tax software to avoid such simple errors. Both can walk you through a series of questions to uncover income sources and to ensure deductions are legitimate.

If you do prepare your own return, some professionals will review it for a reduced fee. And tax software often includes online or telephone access to a professional tax preparer. For an additional fee, a sole proprietor who uses tax software often can have a certified public accountant or an enrolled agent represent him or her during an IRS audit.

To increase the odds that your small business won’t get to that stage, pay attention to these potential audit triggers:

* Home-office deduction. Despite the popularity of home offices, most of them probably would not qualify under strict IRS rules that ban non-business activities, such as working on the family finances or hobbies, in those spaces.

“We tell customers this is an area that the IRS frequently looks into, not to scare them away but to ensure they are doing it accurately,” said Bob Meighan, a vice president at Intuit Inc. The Mountain View, Calif.-based company’s products include TurboTax, Quicken and QuickBooks financial software.


* Sustained losses. The IRS will typically give a new business a few years to get on its feet. After that, losses probably will be looked at more carefully. The agency is particularly interested in weeding out losses associated with what it considers hobbies rather than legitimate business activities. Prove your profit motive by keeping formal records, and be sure to separate your business income and expenses from personal accounts.

* Expensive business gifts. Just $25 of each business gift is tax deductible, so the IRS is interested when a company is giving out lavish presents, said Strauss of BDO Seidman.

* Low officer salaries. Failure to take a reasonable compensation from your S corporation is a flag to the IRS that you may be underreporting your true income and thus avoiding income and payroll taxes. Tax professionals have varying methods to calculate a “reasonable” salary. Some suggest the corporation set aside 50% of profit for salaries, others suggest claiming at least the full amount that is subject to Social Security and Medicare tax, which last year, would have been about $94,000.

* Large inventory write-offs. At the end of the year, a company will often write off the value of all or part of its inventory and claim it as a loss. The write-off cuts the value of its inventory assets, thus reducing the cost of goods sold and its gross profit.

It can be a legitimate move or an attempt to manage income, experts say.

“There is some temptation to adjust that balance if they believe their taxable income is too high,” Strauss said.

* Relatively low business meals and entertainment expenses. Since only 50% of these expenses are deductible, some small-business owners may try to lump them into other, fully deductible expense categories, such as advertising costs.

The IRS uses computer models to score a company’s return. If income or expenses fall outside of the expected ranges for the filer’s tax bracket and industry, the agency will take a closer look.


* Cash business with large expenses. Large expenses and low income will catch the attention of the IRS, which is scrutinizing cash businesses more thoroughly as likely sources of hidden income.

* S corporation status. S corporations are being targeted for a number of reasons, including the fact that many are former C corporations and may still owe certain corporate-level taxes.

The built-in gains tax is one example. If, for instance, a company bought some real estate while it was a C corporation, then sold it after converting to an S corporation, it would owe corporate-level taxes on all or part of the sale proceeds, as well as the tax the S corporation shareholders owe when they receive their share.

“You really have to be aware when you are preparing these returns,” said Vicki Mulak, owner of American Financial & Tax, a Tustin firm that specializes in small business. You can learn more about IRS rules and potential audit flags at the agency’s website: