IRS audits of small business tax returns are up – way up, and headed even higher. The Internal Revenue Service has said loud-and-clear that it believes roughly $100 billion of income from small business, home office and other solo-operator sources goes unreported each year. 

Small business tax audits are up; Don't be next!

As a result, the tax collecting agency has amped up an enforcement effort aimed squarely at a wide range of small business returns, including S-corporations, LLCs, partnerships and especially sole proprietors, who generally use a Schedule C to a personal 1040 return to report business-related income. The audit stats get ugly. Sole proprietors – the most dominant form of small biz ownership – are 10 times more likely to be audited than other business entities.

It’s little wonder. The IRS spends less to pursue big corporations, wealthy tax cheats and money-laundering drug lords combined than it does going after small business owners.

If there’s “good news” here, it’s this: You can lower your odds of a tax audit by taking certain steps with your tax return, and avoiding others – you just need to be “DIF” score savvy. DIF is hush-hush Fed-speak for “Discriminate Information Function,” the super secret IRS sauce that decides if your small business related tax return is ripe for an audit. While DIF details are, well, secret, the steps below can help you avoid the audit hook. Each choice you make (how to file; when to file; what deductions to claim) has an impact on your audit odds. Here are 16 things you can do:

• 1. Be accurate, thorough, neat and on-time (but not early). Sloppy returns, math errors and rounded numbers raise flags. Using tax preparation software makes your return look more professional and helps you avoid mistakes. Filing early only gives the IRS extra time to look it over. Accuracy starts with keeping good records; if the IRS ever questions anything on your return, the burden will be on YOU to prove it’s right. If your records are sloppy, this will be difficult.
• 2. Avoid filing electronically. Sure, electronic tax return filings are convenient, and in some cases even required. But the IRS hires temps to enter data from millions of paper returns, and they capture only about 40 percent of the info. Electronic filing gives IRS fast access to 100 percent of your return.
• 3. Explain yourself clearly. Avoid vague expense categories such as the infamous category some business owners use called “miscellaneous.” If your business is claiming unusual deductions of some kind – anything an IRS reviewer might not have come across a thousand times before — provide an explanation or documentation.
• 4. Make your estimated tax payments and issue 1099 and W2 forms on time. Late quarterly and estimated payments, non-payments and underestimated amounts draw IRS ire. Know the deadlines and meet them. File 1099s and W-2s using easy online tax services such as FileTaxes.com which are cheap and easy.
• 5. File on time: This is kind of a no-brainer. Late returns raise flags. It’s easy to file for an extension, so there’s little reason to miss the initial deadline. Just remember that any money you owe is still due by the original filing deadline; the extra time is for doing the paperwork.
• 6. Beware of your income-to-deduction ratio. Your tax audit odds for a small business rise if the difference between expenses and income exceeds about 52 percent. But total deductions are only part of it. One especially large deduction can also raise flags, even if others are small or in line with other businesses in your industry.
• 7. Inc. yourself. Sole proprietors who file a Schedule C for each business get audited most. To avoid the higher risk of sole proprietor audits, consider making your business a corporation or limited liability company (LLC).
• 8. Hire a CPA or other tax pro. Tax rules that affect small business are impossibly complex, far-reaching and downright confusing. Even for relatively straightforward situations, getting professional tax preparation advice can be a huge help in avoiding audit triggers for your particular case or industry. Check online sources for different types of accounting firms and CPAs specializing in your area.
• 9. Be wary of taking a home office deduction. Tax returns that include a deduction for a home office are a prime IRS target, so if you plan to take a home office tax deduction, make sure you know the rules. A home office must be a completely separate room or area used exclusively for business. Here again, a CPA can be invaluable in helping you do it right, or perhaps deciding that the benefits aren’t worth the hassle.
• 10. Avoid the independent contractor trap: Another favorite IRS target – one they are convinced yields a lot of extra cash – is miss-classified workers. If your business uses freelancers and other types of independent contractors, make absolutely certain they qualify for independent contractor status or the IRS may determine they really are employees and stick you with a big bill for back payroll taxes plus penalties.
• 11. Watch those startup cost deductions: Many startup entrepreneurs and new business owners assume that money they’ve spent to get the business up and running can be deducted immediately. But that’s not always the case – many startup costs must be “depreciated” over time. (Check out the latest “bonus depreciation” tax rules for small business included in the 2009 economic stimulus bill.)
• 12. Don’t “forget” to report income: The one thing the IRS hates above all else is unreported income. And don’t kid yourself – the tax agencies are far more sophisticated about tracing money than they’ve ever been. Also remember that the IRS has extensive data on typical income levels and deductions for every type of business that exists. If yours is out of line with others like you, an audit could result.
• 13. Don’t mix personal and business deductions: The IRS is on the lookout for small business owners who try to deduct travel, entertainment or other costs (cell phones, merchandise, etc.) that are really personal, and not business related. Remember that only business-related expenses can be deducted. Make sure you understand the rules on what portion of business entertainment costs are allowable as a deduction. And avoiding taking mileage deductions for personal use of a vehicle…another IRS audit hotspot.
• 14. Make your hobby a true business: If the business you are claiming all those deductions for looks more like a hobby to the IRS, you could trigger an audit and end up owing back taxes. A real business has revenues at least some of the time, and looks, acts and spends like a business as well.
• 15. Report barter and auction income: The fair market value you receive through business barter transactions may indeed be taxable, even if you did not receive cash. Likewise, income generated from selling items via online auction websites needs to be reported.
• 16. Be honest. Every year, the IRS gets better at using high-tech means to track your business income. And some things are just obvious. If you claim lots of expenses, but show little revenue to pay for them, the tax folks get curious.