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Avoiding a Tax Audit
-February, 2011


Download a pdf of the Fiducial Small Business Update newsletter.
Fiducial Small Business Update



We’ve all heard the claims that the IRS has increased its staff in order to perform more audits and increase revenues. For small businesses fearful of facing that tiny white room with boxes of receipts in hand, there are several steps you can take to reduce your chances of being audited.

Report all of your income

The primary reason for receiving an audit notice is that your business’ reported income does not match the IRS’s 1099 and W-2 documentation for what you’ve actually received as payment from others. Make sure you report all income and don’t try to cut corners especially at year end. One instance that can be confusing to business owners operating on a cash-based accounting system is year-end income. For example, you’ve invoiced clients in December. In return, you receive payment in January check dated in December. Your client will be claiming that expense on their 2010 1099-MISC even though you didn’t receive the payment until 2011. How should you record and more importantly track this payment for tax purposes? One method is to include the payment as it is recorded on the 2010 1099-MISC and then subtract it from your 2010 income with an explanatory note. You will then claim the amount in your 2011 taxes even though you won’t receive a 1099-MISC for the amount.

Be thorough

Review your return, or have your accountant or tax preparer review the completed return, for any missing information. Remember to attach all separate schedules necessary for your return and include your tax identification number on each form. To avoid unnecessary questions, be sure to add any explanatory information such as the scenario above for reporting year-end income.

Double check for mathematical errors

It may seem obvious to provide correct entries, but simple math errors are quick triggers for further inquiry into your return. The IRS reports a low one percent error rate on those returns filed using electronic filing versus a 20 percent error rate on paper returns. E-filed returns won’t even submit to the IRS, rather they will be returned for correction and refiling. However, an electronically filed return doesn’t guarantee you a free pass on an audit. The information you provide must be legitimate and have receipt back-up the same as any paper filed return.

Limit your exposure

The IRS actively pursues those tax payers with reported incomes over $100,000.


According to former IRS Commissioner Charles O. Rossotti, “those who make more than $100,000 pay more than 60 percent of the taxes” which forced the IRS to redirect their limited resources there. What can you do? Talk with your tax preparer or accountant about possible income allocation strategies. Many small businesses prepare their tax statements as a single family unit. You are well within the confines of the law to submit as married filing separately where you can allocate income to separate family members and allocate dollars to a lower tax bracketed member.

Turning your hobby into a business?

Avoid filing Form-5213, “Election to Postpone Determination as to Whether the Presumption Applies that an Activity is Engage in for Profit”. This form indicates to the IRS that you are requesting a five year ‘review free’ period while you demonstrate that the business is capable of making a profit. You can almost guarantee that submitting this form will garner an audit at the end of year five. A smarter option is to start the business, keep careful records for expenses, profit and loss and cash flow and demonstrate that the business is a legitimate venture.

Consider changing your business entity

Recent shifts within the IRS have made small business a prime target for audits. If you are operating a sole proprietorship or even a limited liability company, you may want to investigate the feasibility of becoming incorporated. Filing a Schedule C leaves your business ten times more likely to be flagged for an audit than someone who is incorporated. You can reduce your personal risk and increase deductions by becoming incorporated.

Follow the Scouting Motto

With an experienced tax preparer, CPA or Enrolled Agent at your side, you can be well prepared should you be selected for an audit. If you can keep copious records, have all necessary receipts and documentation and take only valid deductions you’ll have nothing to worry about. If and when you are called for an audit, it will be quick and painless.

Look out for ‘constructive dividends’

Remember that trip to Disney you took while ‘at convention’ in Orlando? So will the IRS. Unless the conference was held on Disney property and the entire convention was scheduled to tour Hollywood Studios as part of a learn-how-great-Disney’s-marketing-is, it is doubtful that your IRS auditor will allow the gate ticket as a legitimate business expense. If you take personal expenses, report them in your personal income tax return and reimburse the company for the expense. Talk with your accountant about the possibility of treating the expense as compensation or dividend. Whatever you do, be sure to record the expense accordingly and don’t try to sneak the purchase by as a legitimate business expense.

If you have questions about your small business’ taxes, call a trusted tax professional before you make any decisions. The IRS has tips for choosing a tax preparer on its web site or you can call a Fiducial Advisor at 866-FIDUCIAL or visit the web site at