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Audits on the Rise
IMR, March 15, 2004
The Internal Revenue Service added 2,000 new positions to its enforcement operations in 2002 and began conducting random audits for the first time in 14 years. It plans to hire 2,200 more auditors next year. The ramping up of audits fits the plan of new IRS Commissioner Mark W. Everson, appointed last May.
"His main goal these days is compliance, compliance, compliance," says Cindy Hockenberry, an enrolled agent and information coordinator with the National Association of Tax Professionals, Appleton, Wis. "He looked at the books and saw there was so much money being left uncollected. He wants to make sure taxpayers are paying their fair share." That includes small businesses.
Companies can help avoid audits by making themselves less vulnerable. Although you certainly want to check with your tax professional for specific advice, there are several ways you can protect your firm. First, document all expenses. "The best defense is to have substantiation for your deductions," says Hockenberry. "If you're going to mention something on your tax return, it must be an 'ordinary and necessary expense'--and that's broadly defined--and you must be able to support it."
Companies often keep paperwork for expenses such as equipment, but are less inclined to hold onto receipts for smaller items, such as business meals, parking garage tickets and gas receipts from business trips. If you take a prospect to lunch, for instance, Hockenberry recommends not only keeping the receipt, but also marking it with the prospect's name and business purpose. "Any entertaining, whether it's taking your whole office on an outing or a one-on-one lunch, stands a much better chance of getting by the IRS if you can substantiate it with a time, place and business purpose," she says.
At the top of the list of deductions the IRS deems questionable is automobile expenses. For example, if you claim your car is used 100 percent for business, Hockenberry says the IRS is going to ask questions about how you get to the grocery store, gym, doctor's office, etc. In addition, while a delivery truck won't raise any eyebrows on your tax return, a Jaguar might. If you deduct mileage expenses, Hockenberry encourages you to maintain a logbook or track mileage in your PDA. "Track every trip--dates, miles, locations to and from," she says. "Keep the logbook in your glove compartment."
Another target of the IRS are shareholders/employees of "S" corporations who might take excessively large dividend payments in place of salary. With "S" corporations, income passes through to shareholders rather than going to the business itself (like a more traditional "C" corporation). The problem with large dividends is that they enable businesses to avoid payroll taxes for items such as Social Security and Medicare. Hockenberry says the IRS relies on surveys to determine the average salary of a person providing similar services who does not own a company. "If you pay yourself $5,000 and the average is $60,000, you're in trouble," she says.
Again, documentation is critical in defending seemingly excessive dividends. For instance, some company owners decide to wave salaries during the first few years of operating a business until there are sufficient profits. Such decisions should be recorded in company minutes. "Minutes are very important if you have a corporation," says Hockenberry. "They help support what you do."
Hockenberry admits that documentation is time-consuming. But it could save you during an audit. "It's a little extra work, but it's an insurance policy," she says. "You keep good records because if you're audited, they're a lifesaver."