Tax Man, Stay Away From My Door

How entrepreneurs can minimize the odds of an audit

First the good news: Internal Revenue Service auditors are expected to pull fewer returns this year than they did during their aggressive crackdown of the mid-1990s. Now the bad news: Small businesses and self-employed professionals are still the favored targets. How can you reduce the odds of getting hit? Ask yourself, "Am I raising red flags that attract auditors' interest?" Here are some good questions to start with.

Q: Are specific industries or types of business more prone to audits?

A: Cash-based businesses, such as restaurants, construction companies, and retailers, are still at the top of the agency's hit list. The same goes for self-employed individuals earning over $100,000. This group--crowded with doctors, lawyers, freelance writers, and other professionals--was audited at nearly twice the clip (4.13%) of similarly paid company employees (2.27%), according to 1997 IRS data. Partnerships, including LLCs, were examined at a far lower rate (0.59%)--though accountants expect that rate to rise as more businesses form as LLCs.

Q: How do the expenses I claim affect my chances of being audited?

A: First, go easy if you want to stay off the radar screen. The IRS typically flags Schedule C and corporate filings that show a net loss resulting from high expenses, says Murray Alter, tax partner at PricewaterhouseCoopers in New York. Also, business travel and entertainment remains a perennial IRS sticking point, particularly if your T&E expenses gobble a high percentage of revenues or exceed what's typical for your industry peers.

Generally, you can deduct only 50% of meal and entertainment costs. So it may not be worth it to claim every business-related Caesar salad. "If you're overaggressive, they may flag you," warns Barbara Steinmetz, a Burlingame (Calif.) financial planner. In fact, she recommends withholding a few T&E expenses as bargaining chips in case of trouble.

Other possible red flags in the expense department include hiring only independent contractors instead of salaried employees and overly large outlays on gifts (the IRS only allows you to deduct gifts of under $25).

Q: Does the way I state my revenues affect the chances of an audit?

A: If you've been in business a while, there's no brighter red flag than reporting little or no revenues. That's because the IRS will question whether you're actually running a business or just dabbling in a not-for-profit hobby, says Kent Noard, a San Jose (Calif.) financial planner. A "business" must produce profits in at least three of the last five years.

If your company has a product that is still in development, watch out: You won't be able to deduct pre-opening expenses such as market research, R&D, and business licenses until you actually start selling your product. Even then, you'll have to amortize them over five years.

Q: Are there any special risks if I decide to do my accounting with one of these snazzy computer bookkeeping programs?

A: Use of a program itself does not trigger any special audits, but you might become more audit-prone if you rely on them exclusively for tax preparation. Why? Computer bookkeeping programs generally follow the rules of financial accounting rather than tax accounting. "There is not much conformity between the two of them," says Diane Herndon, Ernst & Young's national director of accounting methods. For example, financial accounting rules allow you to spread up-front payment for a three-year contract evenly over three years. But the IRS demands they be counted as one entry.

Q: What special concerns will the IRS have if I do business abroad?

A: Foreign currencies present the biggest challenge. You will have to convert those funds to U.S. dollars, according to standard accounting rules, and place them on an American-style balance sheet, says Alan E. Weiner, senior tax partner at Holtz Rubenstein & Co., in Melville, N.Y. What's more, the IRS tends to look more closely at individuals who show that they are holding more than $100,000 in foreign banks, says Alter of PricewaterhouseCoopers.

Q: Are there any audit risks for owners or partners in S corporations?

A: While overall, S corporations trigger far fewer audits than other businesses (just 1.04% of 2.3 million S-corporations were audited in 1997), be careful about how you pay yourself. Taking out your profits as company dividends rather than in the form of at least a partial annual salary could provoke an audit, too--a risk that is probably not worth the employment taxes you would save.

Before it's here, it's on the Bloomberg Terminal.