Small Business = Higher IRS Audit Risk

Note: This article was written by Douglas Castle, Chairman and CEO of TNNWC Group, LLC, a provider of publications, information and indispensible services (from strategic planning to capitalization) to small businesses, emerging enterprises, and entrepreneurial companies with a high growth trajectory. It was first published in the TNNWC Supplemental RSS and Daily Email Feed Blog. By the way, If you are a TNNWC Member, but you do not receive the RSS feed or the Daily Email Supplement --- you are missing valuable free coverage, ideas and offers. Get it? Get it!

Dear Friends, Colleagues, TNNWC Members, Readers and Accidental Tourists:

If you happen to be the owner of a small business, whether it is duly formed as a legal entity, or if you are merely self-employed, the likelihood of your personal income tax return being audited is likely up to five times greater than that of any "conventionally-employed" individual.

While I do not offer investment, financial, legal or tax advice to any of my readers, colleagues or fellow TNNWC Members, I feel that being forewarned is sometimes the critical hint that leads to the preparation of defensive countermeasures. Consult with your tax professional about what you should do...as if you were already an audit target.

Bear in mind that in a country where the economy is challenged due to any number of factors, the government's first recourse is to collect taxes through any means possible. In accomplishing this feat, the mere threat of an IRS audit is sufficient to have many taxpayers simply accept defeat and come up with whatever amounts the IRS determines that they still may owe. Is this an intimidation tactic (you may ask)? Yes. And it is a highly successsful one, as most taxpayers are a) unaware of their rights, recourse and remedies in the event of an audit, and are b) more willing to simply surrender because of the multiple horror stories which about about the incredible powers of the Internal Revenue Service.

The following article from Investopedia outlines some of IRS' probable criteria in selecting returns for audit. I have highlighted several pertinent sections of the article for the benefit of my readers who have no time for my long-windedness.

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Taxpayers the IRS Is Targeting This Year

Mark P. Cussen

Friday, March 18, 2011

provided by

Out of the millions of tax returns that are filed with the IRS each year, a certain percentage are inevitably flagged and chosen to be audited. In some cases, this is because the taxpayer filing the return is already being investigated for tax fraud or other crimes, while other returns are merely selected at random. The formula that the IRS uses to flag returns for random audit, known as the Discriminant Function, is a highly classified secret known only to a few. However, there are several types of returns that the IRS tends to focus on in general. Filers with returns that fall into one of these categories must accept that there is a higher probability that they will be audited than other taxpayers. Some of the types of returns that the IRS tends to scrutinize more closely include:

Returns that Itemize Deductions

Taxpayers who include a Schedule A with their 1040 likely have a higher chance of being audited than those who don't. This is because the additional calculations invite a greater possibility of fraud or error by the taxpayer.

Self-Employed Taxpayers

Taxpayers who report income on Schedule C or E are prime targets of the IRS, because of the number of expenses that can be claimed as deductions. Those who report net losses for the year that reduce other taxable income, such as salaries or investment income are especially vulnerable to examination by the IRS.

"Cash Cow" Businesses

Many businesses have traditionally operated largely on a cash basis, such as laundry services, restaurants, casinos and gaming establishments and other similar enterprises. A substantial percentage of these businesses have traditionally underreported their income on their tax returns, due to the difficulty of proving revenue that is received in cash from thousands of separate transactions. For this reason, the mafia and other organized crime syndicates have been heavily involved with these industries for the past several decades. Of course, this has not escaped the notice of the IRS, which has collaborated with various law enforcement agencies who pursue these criminals.

Small Businesses

Even businesses such as florists, hobby store owners, construction contractors and other local enterprises are often scrutinized by the IRS. This is because even honest business owners and partners often don't understand the rules for correctly reporting their income and expenses and therefore submit erroneous returns. This is particularly true of those who are filing a business return for the first time, such as the proprietor of a new company.

Private Transactions

Taxpayers who engage in the sale of substantial pieces of real estate or hold interests in oil and gas leases or other such investment property can often realize enormous income and profits from individual buyers or small companies. The IRS knows how easy it can be to underreport the profits from these transactions, in some cases.

The Bottom Line

Remember that if the IRS does flag your return for audit, it does not mean that they suspect you of cheating. As mentioned previously, many returns are selected at random, according to a formula. As long as you have not cheated on your return, then you don't have to worry about what they find. If there is an error, the IRS will notify you in writing of the discrepancy and tell you how much more you owe. Of course, this process can work both ways; it is possible that the IRS could state that you owe less than you reported as well. Just make sure that you have all of the documentation that you need to prove your deductions, such as copies of receipts and bills. As long as you can supply what the IRS requests, your audit should be a relatively quick and painless process.

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Dear Readers:

Having read all this, please remember that as far as the IRS is concerned, you are not only guilty unless and until proven innocent, but if you are a sheep (whether innocent of any tax infringements or not) and not a wise wolf (dangerously capable of launching a vigorous defense), they will eat you alive. Sadly, your ingnorance, fear and limited budget for self-defense are the IRS' greatest advantages.

Repeat: The best defense strategy is often to prepare for the absolute worst.

Faithfully,

Douglas Castle