Do you, as a small-business owner, fret about the possibility of a tax audit? Well, perhaps you should. "Small businesses are audited more than any other entity," warns Amir Aczel, a statistics professor at Bentley College in Waltham, Mass., and author of How to Beat the IRS at Its Own Game ($10.95; Four Walls Eight Windows). And that's likely to increase: Uncle Sam plans to double the number of audits of individuals, including doctors, freelance writers, and other sole proprietors who file the Schedule C form showing profit or loss from a business.
But if you own a small business, you can take steps that will lower your probability of being audited. Most important, you should minimize deductions. The Internal Revenue Service is most likely to audit you if you show a high ratio of deductions to income on three schedules: C, A (itemized deductions), and F (profit or loss from a farm).
DANGER ZONE. As a rule, your expenses should amount to no more than half of your gross income. Aczel breaks out precise ratios for each schedule, based on a study of 1,200 real returns, half of which were audited. Schedule C filers, for example, have little chance of an audit if expenses are less than 52% of gross income. They hit a "cautious" zone from 52% to 63% and a danger zone when expenses top 63%. For Schedules A and F, you're safe if deductions are under 35% and 59% of gross income, respectively. Beware when expenses hit 44% for Schedule A and 67% for Schedule F. Pass those percentages, and you're in the danger zone.
What if your Schedule C deductions are high enough to attract the IRS's attention? You can shift costs to different lines to lower your ratio. Take costs of production such as employee salaries and supplies: In some professions, it could be appropriate to report those expenses under Cost of Goods Sold rather than Total Expenses, says Richard Collier, a Cleveland tax attorney. Credit-card fees, postage, and--if you're a doctor--malpractice insurance can appear under Other Costs.
Another option is to shift expenses from Schedule C to Schedule A. The IRS computer flagged Aczel's 1989 return for his Schedule C expenses, which were 85% of his income, when he was writing a textbook. Aczel had bought expensive reference books he used as an author and as a professor. He could have attributed some of the reference-book expenses to textbook writing (Schedule C) and some to his college job (Schedule A).
If you work at home, avoid potential trouble by using the home-office deduction sparingly. "This is the quickest trigger to an audit," says Joseph Newpol, a tax attorney in Lexington, Mass. With 34 million Americans working from home, "the IRS sees it as an easy way to squeeze more money from taxpayers." Only claim the deduction if you use the space regularly and exclusively as your main workplace. If the IRS agent turns on your computer and finds your kid's homework, the deduction will be disallowed. Read IRS Publication 587, Business Use of Your Home, for guidance.
If moonlighting at home, separately deduct your computer, supplies, and entertainment expenses on Schedule C. Log what percentage of the time you use your computer for business, then prorate the expenses. Record on each receipt whom you entertained or why you traveled for business.
Something that might set off IRS alarms is a big income or expense swing between recent years. For example, if you take out a $100,000 home-equity loan and pour the money into your company, you add a substantial sum to your budget without a comparable rise in taxable income. Don't be shy about attaching an explanation to your return. "Taxpayers feel the less they put in their returns, the better," notes Michael Janicki, a BDO Seidman tax partner. "That's not always true."
BE PRECISE. Schedule C filers with business revenues of more than $100,000 have nearly a 5% chance of being audited, compared with less than 1% for S Corporations. So one of the best ways to avoid an audit is to avoid the Schedule C by becoming an S Corporation (also called a Subchapter S). Once you start hiring employees, which increases your personal liability, consider incorporating. S Corporations have more administrative details and fees than sole proprietorships, but they also have all the benefits of regular corporations, like liability protection and health benefits, without the disadvantage of double taxation on profits and income.
The simplest way to prevent an audit? Watch for discrepancies in your numbers. The IRS gets statements of income and expenses from 1099s and W-2s. These must match what you file. Avoid math errors, naturally, and round numbers: Resist the temptation to turn $10,010 into $10,000, for example.
If an IRS agent comes knocking, anticipate questions and be ready to document every deduction and expense. Prepare answers where documentation is fuzzy. But of course, if you take care not to give the IRS any obvious bait, you can greatly lessen your chances of getting bitten.