December 12, 2016

As entrepreneurs, most of us have a very interesting dynamic in our tax planning.

We have no one to pay our self employment taxes.  We also often have payroll taxes that we are paying for others.  This means that our tax liabilities may be higher than the average person.  However, as entrepreneurs, we also are able to deduct certain expenses, that employees are not.  This leads to a perpetual catch 22 in tax planning – to take the deduction or not to take the deduction!

Have you ever been audited?  I have… twice, and it is NOT a fun experience!  Fortunately for me, I’m ridiculously particular about my documentation, and both audits led to no changes in our returns, but I can tell you that an IRS audit often creates hours of work, worry, and stress, for even the most prepared!

Although audits don’t happen terribly frequently (only about 1 in 118 tax returns), they happen often enough that it is something you want to be mindful of – especially if you make more than $200,000 per year.  People with income of over $200,000 had an audit rate of about 1 in 37 returns, not 1 in 118.

First, in the event that you are ever audited, you want to make sure that you have ALL documentation.  When you receive the letter from the IRS saying they want to audit you and your returns, it causes you to second guess yourself and start pouring through your returns, receipts, quickbooks, and spreadsheets with a fine tooth comb!

Here are some red flags that may increase your likelihood of tax audits…

Failure to report all income.  Have you noticed that the IRS wants tax payers to submit their returns online vs in paper formats?  The reason is that they have set up systems so everything is reported electronically and they can match up the income you report on  your return to the income reported on W2’s, 1099’s, etc.  So if you aren’t honest, they will know, and that will automatically encourage them to check the rest of your return with a fine tooth comb!

Higher than average deductions.  If you have claimed a larger percentage of deductions for your income than the average tax payer, then you will potentially be flagged for review.  If you actually incurred these expenses and have the back up to prove it, then don’t be afraid to take the deductions.  But don’t embellish expenses if they aren’t valid to reduce your income tax.

Self Employment.  The IRS knows that one of the places where deductions may be higher than normal is in a self employed return (a Schedule C).  Self employed people may deduct travel, dining – a number of things that the normal W2 taxpayer isn’t deducting.  So, the IRS is much more likely to audit a Schedule C than a typical tax return.   If you ARE deducting meals, travel, and entertainment, make sure that you are tracking exactly who attended and what was discussed or the event and deduction may be disallowed.

Using 100% of your vehicle for business purposes.  First, the IRS pretty much knows that it is almost impossible that your vehicle is used 100% for business reasons!  If you are using a vehicle and deducting it for business purposes, you need to ensure that you are tracking the use of the vehicle and that you are only deducting the actual use of the vehicle.  Also, you can deduct either a mileage allowance OR the business use percentage of the actual expenses of the vehicle, not both.  So you will likely want to talk to your tax preparer to determine the best scenario based on your personal situation.

Claiming a hobby as a business.  Many people start “businesses” exclusively for the tax benefits and never have any intention of making a profit with the business.  The general rule of thumb is that you should make a profit at least 2-3 out of five years.  If you do not, there is a possibility that the IRS will consider the business a hobby and disallow any deductions.

Claiming a home office deduction.  A home office deduction is another place where the IRS knows that they can potentially make some gains in an audit.  If you are deducting a portion of your home as an office expense, it must be used exclusively for business purposes.  So, you can’t deduct the guest bedroom that has a desk in it as a home office.  And if you’re a W-2 employee, you want to be careful about deducting a home office.  

As a taxpayer, you should never pay more in income taxes than you are required by law.  As an entrepreneur, you have more deductions available to you than the typical employee tax payer.  However, just be aware of the deductions that the IRS watches more closely, and ensure that you have all documentation to substantiate your deductions! Also, if you feel that your deductions may be a bit “aggressive,” it is advisable to work with a tax planner to ensure that you are taking all deductions available to you, within the confines of the tax code!