Welcome to the official blog of Brittany Lanphier, managing partner of Lanphier Accounting LLP based in Westminster, Colorado!
Any tax guidance in this blog is intended for informational purposes only and is not guidance on which Lanphier Accounting LLP intends for you to rely. All tax issues specific to your business or family are largely facts-and-circumstances based and you should consult your tax advisor (or Brittany directly) to discuss how this might relate to you.
Well, the blog has had to take a little breather during tax season. As much as I love writing it, I am not willing to push a 1:30 am bedtime to 3:30 am on any given night to update it! Lesson #112 I’ve learned about running my own business is the importance of prioritizing – and of making my own health and well-being at list half-way up that priority list!
So, this may be an abbreviated blog post, but wanted to get something up none-the-less. After several large projects successfully completed last week, I have had a little time to catch my breath before things ramp up again for April 15th.
Last week, I had the privilege of spending two whole days with an IRS examining agent at our office as she audited one of our clients. Call me an accountant, but I actually enjoy the challenge of the audit process and the opportunity to advocate for my clients.
Dennis and I also enjoy working on IRS examinations because it gives us the perfect opportunity to team up and maximize our individual skill sets for our clients. Dennis is far better than I at tax research, technical analysis, and legal writing – and I thrive on the organizational, presentation, and tax return-specific aspects to each audit.
I am pleased to report that not only did we successfully defend all of our clients positions, but were also told by the agent that it was one of the most comprehensive presentations she had seen in an examination.
So, in honor of the IRS and in honor of the April 15th deadline fast approaching, this week’s tax section is dedicated to some of the top audit triggers for small-business owners.
Now, getting audited is not the end of the world. It can, however, be costly since you will be best served hiring professional representation such as a CPA or an attorney.
Which should you hire? For the examination phase of an audit (the first step), I highly recommend that you have a CPA on your case. A CPA will be much better suited to analyze your tax return and advise as to all the documentation necessary for a sound defense. Another bonus – a CPA will probably be cheaper too! If you receive an unfavorable outcome in examination, you are entitled to appeal the decision, and it could go all the way up to Tax Court. Once it reaches this point, it may be wise to bring legal counsel on board to help with some of the litigation aspects of resolving a case at this level.
With that said, let’s move on to…
IRS Audit Triggers for Small Business Owners
Small business owners need to be particularly aware of red flags that will make you more likely to be selected by the IRS for an audit. The number one rule tying all of these together is to document, document, DOCUMENT. As a small business owner, keep everything. The IRS will not “take your word for it” if it comes time for an audit.
According to The Wall Street Journal, your chances of being audited are pretty small. In 2008, the IRS audited less than 1% of the 137 million tax returns that were submitted. Your chances increase to 2.54% if you make over $200,000 per year and to 5.94% if you make over $1 million.
What are they looking for? Well, here are 5 red flags that could make you more likely for an audit (borrowed from USA Today):
1) Cash-Based Businesses
Often when businesses receive a high percentage of their revenues in the form of cash, the owner might “forget” to report a little bit of that income. According to the USA Today article, gas stations and convenience stores are one of the most audited businesses each year for this very reason.
If you deal with a lot of cash in your line of business, make sure to keep detailed records. If at all possible, invest in a good software program to manage all of your sales and provide reconciliations between all cash sales, bank deposits, and petty cash accounts.
2) Mixing Business and Personal Expenses
There are many reasons not to commingle business and personal funds as a small business owner and the appearance of such practices under audit is one of them. Avoid running through any personal expenses that are not legitimately related to your business (like your gym membership or haircut).
You might argue that you need to be in shape or have a stylish cut to be a successful business owner. A good rule of thumb is if you would still need it if your business didn’t exist, it’s probably not an “ordinary and necessary” business expense. Therefore, if you would need your haircut regardless of whether your business was open or not, then you probably shouldn’t deduct it.
3) Entertaining Expenses
This is another point of much contention under audit. On the one hand, there are entertaining expenses that are most definitely “necessary” to your business and the IRS knows this. On the other hand, they need to be prudent in the light of your industry and the overall health of your business. If your business is losing money, its going to be a tough sell to convince the IRS that you need that lavish party or golf trip with all your buddies/clients.
Don’t let this scare you from taking the meals and entertainment expenses that you are rightfully entitled to, however. “Reasonableness” is the name of the game. Just don’t forget that you only get to deduct 50% of your entertaining expenses, and you will want documentation to show that you played by the rules. I recommend keeping all receipts and writing the names of each person at a meal or event on the back to remind you of why it was necessary later on.
4) Losing Money Three Out of Four Years
The IRS is particularly sensitive that taxpayers don’t write off their “hobbies” as a business operation. Therefore, if you are consistently operating at a loss, you are more likely to get audited. This isn’t to say that you can’t substantiate the losses, but you will want to maintain ample documentation.
5) Taking the Home Office Deduction
Every client that walks into my office and does any work from home asks me about the home office deduction. The truth is that the requirements for this deduction are pretty narrow and many people do not qualify for it. You must have a section of your house that is exclusively used for business (i.e. not an office/guest bedroom). It also requires a fair amount of estimates on the part of the taxpayer. The IRS loves to challenge this as they know many of the components of this deduction are rather subjective and open to manipulation.
Obviously, this is not a comprehensive list of all the issues the IRS might pursue on an audit. Again, the name of the game is documentation to substantiate everything on your return. Of course, it helps to use a professional to prepare your taxes in the first place. This is no guarantee that you won’t be audited, but they can at least advise you of areas that may raise eyebrows at the IRS. Additionally, a CPA can help you avoid small (or big) errors that are easy to make when preparing on your own.
If you do get a friendly notice in the mail that you have been selected for audit, don’t panic. But do call your CPA (or us) to help you map out the best course of action. You will want to get the issue wrapped up as soon as possible, and a poorly managed audit can drag on your years.
Well, back to the tax returns for me. As always, feel free to contact me with any specific questions about your personal or business taxes.
Best to all,
Lanphier Accounting LLP
600 17th St., Suite 2800 South
Denver, CO 80202