The tax man may be a little more intimidating this year, for many small-business owners.
Faris Fink, head of the Internal Revenue Service's small business/self-employed division, told attendees at the American Institute of CPAs National Tax Conference last fall that the government would be shifting its top audit priority away from corporations. Now, they will be keen to examine returns from partnerships as well as S corporations, sole proprietorships and other pass-through entities.
But getting audited still isn't a big risk. "The percentage is very, very, very small," said Melanie Lauridsen, a technical manager with the AICPA.
The IRS is both underfunded and short-staffed, she said, which has resulted in falling audit rates in recent years. In 2013, S corporations and partnerships both had audit rates of 0.42 percent, down from 0.5 percent in 2012. Corporations with assets of less than $10 million had an audit rate of 0.95 percent, down from 1.1 percent a year earlier, while individuals filing a Schedule C or E saw audit rates ranging from 1.2 percent to 3.6 percent.
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That's small comfort if you're one of the unlucky few, but experts say there are several steps small-business owners can take to minimize their risks and get through relatively unscathed:
1) Spot audit red flags
"There's no way to completely shield yourself from audit, but there are things you can do to minimize your exposure," said Barbara Weltman, a tax and business attorney based in Vero Beach, Fla. An easy one: double-check numbers and totals for reported income. "It's so easy to transpose a number, or leave off a digit," she said. Audits often stem from the IRS checking your figures against those reported by other sources, and coming up with a different total—or spotting income you didn't report. Pay attention to limits on dollar or percentage amounts for business deductions, said Weltman, who is also the author of J.K. Lasser's "Small Business Taxes 2014." "For example, a business meal, you can only deduct 50 percent," she said. "So if you take 100 percent, that's going to stand out."
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2) Maintain records
Audits undertaken in 2013 probably weren't for returns filed that year. "Normally, these things are selected anywhere from a year to 18 months after you file," said tax attorney Fred Daily, author of "Stand Up to the IRS." "There's quite a lag time in there." Keep copies of filed returns and supporting documentation for at least three years from the date of filing or the return's due date, whichever is later. That's how long the IRS has to audit most returns. That stretches to six years if income was misreported by 25 percent or more, and there's no statute of limitations on fraudulent returns.
3) Keep calm and carry on
"If the IRS is coming to you, they think there's something there, and you've got some explaining to do," said Daily. But such field audits are rare: the suspected fraud must be substantial enough to justify the expense of sending an agent to your place of business to review those past years' returns. "The most common audit nowadays is the correspondence audit," he said. "It's really more of an edit correction." Then, the IRS asks you to mail in more documentation—or even just sends an invoice for tax and fees owed after auditors discover a mistake (say, math errors, or a missed 1099 for a small amount) and recalculate the return. "There should be no problem if in fact the documentation exists and you have it to send," said Daily.
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4) Substantiate unusual deductions
Because they look at so many returns, the IRS has a gauge of what income and expenses are typical for a given business, said Lauridsen. Having higher-than-average expenses or unusually low income, or even a loss, is a common audit red flag. With that in mind, if there are perfectly legitimate reasons for your unusual numbers, it can help to have proof in supplemental materials—an insurance claim pointing to losses after a natural disaster, for example, or ads detailing your newly expanded services. In particular, the IRS tends to take a hard look at entertainment and travel expenses claimed for business, she said. Receipts, meetings schedules and mileage logs may be necessary to claim a trip or vehicle as a legit expense.
5) Call in help
If the audit is covering something more complicated than a miscalculation, consider pulling in a tax expert for advice on how best to proceed. "You don't want to open up areas that the IRS hasn't raised, and as a layperson, you might do that," said Weltman. Most small-business owners use an outside preparer; ask if he or she has experience handling audits. "If you've taken some novel or unusual position, you may need a specialist or tax lawyer," she said.