AUDIT-PROOFING TIPS FOR YOUR BUSINESS
Who does the IRS tend to audit often?
Answer: the Self-Employed who file a Schedule C.
Why the Self-Employed?
The IRS believes you are hiding income and adding non-deductible expenses.
What can you do to protect yourself?
The IRS will “judge” you based on past experience with other self-employed, and many of those do not have good track records. The agent will assume the worst based on horror stories they have been involved in. Many companies/individuals do not do the things necessary to protect themselves even if they did not “cheat” the government.
At the same time, the IRS will react to your personal presentation during your first meeting. The way you come across, the proof you present, and direct answering of questions (that means answering the question asked only, not giving more information than requested) will give the IRS agent a feel for what s/he is getting into.
So what are some basic but specific ways to help yourself in an audit? Here are a few common ones.
-Use a professional accounting program to track income and expenses. This tells the agent that you are trying to run your business professionally. A handwritten ledger, though done correctly, may be filled with math errors. A spreadsheet alone, tells the agent that you do not care about tracking financial information, etc. There are many accounting programs available and many of these are inexpensive. An example of a relatively inexpensive program would be QuickBooks, Peachtree, Microsoft Accounting, and many others.
-When you set up a new accounting program, have an experienced accountant or bookkeeper check it to verify it is done correctly. Furthermore, have them periodically check it to make sure everything is still being done correctly. Often judgments are made concerning expense or liability accounts that may be wrong. A monthly or quarterly check by a professional should not take a lot of time, but will help you keep your records in order. If you feel uncomfortable entering financial information, hire an accountant or bookkeeper to do the work for you.
-Documentation. Every expense or deposit that is entered into that accounting program MUST have a corresponding invoice or deposit slip to match to it. No invoice means you have no proof that the expense is legitimate. This is a must.
-“Red Flag” Accounts are expense accounts that the IRS will almost certainly verify in an audit if they have activity. The main accounts, though others may be included, are: Automobile Expenses or Mileage Log; Travel; and Meals & Entertainment.
: Mileage. If you use a personal car for work and claim a deduction for mileage on business use of that car, there needs to be a written record. The IRS will not accept estimates off the top of your head. I suggest a notebook in the car where you write down the date, beginning odometer, ending odometer, and where you drove on business (not just running to the store for an energy drink or soda). If you truly despise writing it down in a notebook, then jot down where you went in your appointment calendar and keep it with your tax return. If you are audited, you should be able to go back and calculate the mileage based on the notes in your appointment book. Hopefully you had estimated the mileage very close to reality though. You should still have written down the odometer reading on January 1st and December 31st to know the total mileage of the car. If you forgot, hopefully you got an oil change or car repair in January where the shop wrote down your mileage on the invoice, then the beginning, or ending, mileage for the year can be extrapolated.
: Travel must be business related. If your trip is to Las Vegas or some other tourist spot, make sure you have proof of business intent; meaning, if it is a convention, the convention brochure or proof that you met with a company or individual for business purposes- maybe a thank you letter from them or to them. Also, if you stop on your way home to see Mom and Dad, you cannot put your hotel room on the company expense account; only where you stay for business.
: Meals & Entertainment are sure to be scrutinized. If you buy dinner for a client or potential client, make sure you keep the receipt. Also, you need to write the name(s) of the people on the slip along with the purpose of the meeting. Buying a sandwich for yourself at lunch does NOT constitute a legitimate deduction. Also remember that the IRS only allows 50% of the total cost of the meals to be deducted.
-Income. Cash, checks, credit card receipts are income to the company. The first step in an IRS audit is to take the company bank statement and see if the money going in matches the company sales. If not, there will be questions. Next the agent will take your personal bank account and look at all the money that went into it. All money that went into your personal account must be accounted for. This is where you need to record all cash gifts, loans, transfers from savings, etc., or other non-business draw deposits.
-Let a professional tax preparer do your income tax return. An IRS agent will assume that you do not know the tax law well enough to do it correctly, even if you do since tax law is very complex.
These are some of the ways to protect oneself in an audit, but by all means not the only way. Remember that to be a legitimate expense, it must an “ordinary and necessary business expense”. This means you must buy it because you are in business and only because you are in business. Buying a lawn mower when your office has no grass is obviously not “ordinary and necessary”. Buying yourself lunch when you would have to eat if you were not in business is nondeductible. But if your work forces you to travel away from home for an unexpected reason, and it is not reasonable to come back home, then a dinner deduction is acceptable.
The laws are complex. Always ask your tax professional if you are unsure. Also remember that there are many other factors to consider if you wish to follow the law. This brief newsletter is not everything you need to know.
Internal Revenue Service. 2010. Publication 463: Travel, Entertainment, Gift,and Car Expenses.
Bonnie Lee. May 12, 2011. Five Audit-Proofing Tips for the Self Employed. Fox Business. http://smallbusiness.foxbusiness.com/finance-accounting/2011/05/12/audit-proofing-tips-self-employed/#ixzz10abZR1C1.