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IRS eyes more small-business audits

A restructuring announced by the Internal Revenue Service recently could mean that more small businesses see audits of their income tax returns.
/ Source: The Associated Press

A restructuring announced by the Internal Revenue Service recently could mean that more small businesses see audits of their income tax returns.

The IRS said it would be adding 2,200 new positions to its enforcement, or audit, operations in 2005, having consolidated or cut back in other divisions. The agency noted that between 1996 and 2002, its enforcement personnel declined by more than a quarter.

Accountants said they expect more audits of small companies and their owners. And although the staff won't be augmented until next year, agents can still look back at prior-year returns.

"The feeling out there is that they have lost money over the years and they're trying to regroup," said Theodore Kravitz, a certified public accountant with ERE LLPP, an accounting firm based in New York.

Small businesses hoping to avoid audits should start by not making themselves vulnerable. Accountants say that means not putting anything into a return that could raise what they call red flags _ something out of the ordinary, or that's unexplained or excessive.

The excessives tend to come in the form of deducted expenses for entertainment, home offices and car usage.

What is excessive? That depends on a variety of factors _ what kind of business you're in, what kind of expenses you've taken in past years, the amount of your revenue, etc.

Frank Lamanna, a CPA with Ison & Decosimo, a Memphis, Tenn., accounting firm, said problems tend to crop up with car usage because many small business owners use a vehicle for both work and personal activities. Some try to take too big a deduction based on their business usage.

"If they (the IRS) see an automobile as being claimed 100 percent for business, and it's a Mercedes ... it's probably not a delivery truck," Lamanna said. "That's a red flag."

On the other hand, if your business is a limousine service, you can justify deducting the full amount. The IRS will look at the totality of your circumstances.

Another common red flag comes when someone tries to take a home office deduction for part of a bedroom that's used for a PC and fax machine. It's not that you can't deduct expenses for a home office, but it has to clearly be an office.

Perhaps a good rule of thumb in avoiding audits is to use commonsense in deciding what to deduct, and not try to get away with something. It's a good idea to get the advice of a tax professional, especially if you think you might be heading into a danger zone.

Yet another red flag comes from not listing income from a Form 1099 on a Schedule C. Many independent contractors receive 1099s from the people or businesses they work for, and Kravitz said the IRS is making a priority of matching the copies of 1099s it receives with the income reported on returns. Discrepancies lead to an inquiry from the tax agency, and they can also trigger a full audit.

Business owners who file a Schedule C should also be careful about their personal returns. Raising questions from the IRS on, for example, Schedule A or B, can lead agents to start looking into the business part of your return.

Corporations have their own particular red flags. For example, Kravitz said, the IRS is on the lookout for shareholders/employees of what are called S corporations who might take excessively large dividend payments that in reality should be taken as salary. In an S corporation, profits are passed along to shareholders as personal income to them; unlike more traditional C corporations, the business itself does not have earnings.

The problem with an excessive dividend payment is that it enables a business to avoid paying payroll taxes _ for Social Security and Medicare _ on the money, since the corporation considers it a dividend. But the IRS will call it salary, and the company faces penalties and a possible audit.

Lamanna pointed out that a C corporation can have the opposite red flag: Paying too much compensation to employees so the company can avoid paying taxes on its own income.

Again, what's excessive will depend on the totality of circumstances, including the kind of business being conducted, and the usual compensation that an employee in such a business can expect to earn.