As business people we have many decisions to make. One of the most important is that of which kind of business entity we need to be. There are many reasons to choose an entity over a sole proprietorship.
As business people we have many decisions to make. One of the most important is that of which kind of business entity we need to be. There are many reasons to choose an entity over a sole proprietorship. Many set up an LLC or S-Corporation to protect personal assets from business debts, but there are other reasons too. Audit risk is a big one. If you’ve ever been through an IRS audit, you know how invasive they can be. What can you do to prepare your tax returns properly and yet minimize the likelihood of being audited?
Here are a few red flags that are believed to increase the likelihood of audit.
- Math Errors: Simple miscalculations trigger IRS computers to pull a return for review. Adding or leaving off an extra zero or putting a 3 where an 8 should have gone will make calculations not balance and then questions will need to be answered. Often during a correspondence audit.
- Failing to report all income: If you receive W-2’s or 1099’s, then the IRS gets a copy of them too. People often think they can leave off one or two of the 1099’s because “it won’t hurt anything” but then your reported income on your tax return won’t match the income the IRS already knows about so guess what? More questions! Additional tax assessments, and all too often, another Audit.
- Charitable donations: The IRS understands you want to donate to your church or favorite charity, but they also have guidelines or statistics on how much people generally donate. If you report donations that greatly exceed these statistics, they will want to check to make sure you really gave what you say you gave. The average charitable donation is 3% of income nationwide. If you tithe to your church it may not trigger an audit but if you give $20,000 on $50,000 gross income, then it will raise a flag and the IRS will want proof.
- Claiming too many losses or too many expenses on Schedule C: If you have repeated losses on Schedule C, the IRS will start to think your business isn’t a business at all but rather a hobby. Are you really trying to make a profit at this enterprise or just expensing something you like to do? As a hobby, your losses are not tax deductible. Also, even if you have a profit on Schedule C, the IRS has statistics on what each category of expense should be for your business code as a percentage of gross receipts. If you take too much expense, they will likely want proof as to why it is so high.
- Taking the home office deduction: If you have an office in your home that is used solely for business purposes, then you are entitled to take the deduction, but it can be suspect to the Service. If it is too large in proportion to the rest of your house, they may check to make sure it is only used as an office and not as your bedroom or other living space as well. Also people often try to take the entire home phone bill and internet bill as part of the home office deduction when the IRS knows people usually also use phone and internet for personal or family use as well. Taking only a portion of the expense is a better way to avoid questions. You may also use the “safe harbor” method of expensing the home office. If you choose this method, it is far less likely that it will trigger an audit. Sometimes it even comes out better for the taxpayer depending upon what the expenses actually are.
- Using Round Numbers: It is very rare to have all numbers be nice and round. Ending in an even thousand or hundred dollar amount. If you use these numbers, they are likely to think you guessed at the income and deductions. This seems like a no brainer but people actually do it, then are surprised to get that audit notice.
If you legitimately deserve these deductions, I am not suggesting you not take them just to avoid an audit. Take them if they are deserved, but keep a paper trail for proof in case they want proof.
So what is your audit risk if you own a business? Well, if you are a sole proprietor and file a Schedule C with income between $25,000 and $100,000, your likelihood of audit was 1.9% in 2014. Over $100,000 of income raised the risk to 2.3%.
If you have a C-Corporation with assets less than $10 million, the overall risk of audit in 2014 was only 1%. Assets between $1 million and $5 million had a risk of 1.2% and between $5 million and $10 million was 1.9%
If you are trying to avoid an audit, the best entity to have by far is one taxed as an S-Corporation. If you were using a multi-member LLC, Partnership, or S-Corporation in 2014, your likelihood of audit was only 0.4%. That is miniscule, and for many, worth the work needed to set one up. Almost 5 times better than running as a risky sole proprietorship.
If you are chosen for audit, there are two kinds of audit you may go through. The correspondence audit and the field audit. If you get a correspondence audit, all communications will be done via mail. You probably will never meet your auditor and they will not come out to view your assets. In 2014, 71% of individual audits were correspondence audits. If you have a business filing Schedule C but no Earned Income Tax Credit, the correspondence audit rate was 52%. The other 48% faced more invasive field audits.
In contrast, business returns that were audited were far more likely to have a field audit: C-Corporations at 92%, S-Corporations at 91% and Partnerships at 67%. While these are much higher numbers, the total number of audits was surprisingly low compared to sole proprietorships.
By Ken Mullinax