There are several factors that can raise eyebrows at the IRS and trigger an audit, but knowledge is power, and understanding what agents are looking for in a return can help you avoid the hot seat.
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The IRS website contains detailed information that taxpayers can tap into to eliminate--or at least minimize-- the fear and dread that most people experience when dealing with the IRS. The site also provides the training tools used by auditors that can provide clues on what they are looking for in a return. Once you know agents’ mode of thinking, you can adequately prepare. In fact, if you own a small business, you want to organize your documentation so that you are always ready in the event of an audit.
The analysis of income plays a major role in tax returns, and techniques on how to document these figures properly to avoid any issues applies to every entity type: sole proprietorship, LLC, partnership, or corporation.
When it comes to income, auditors will first look at internal controls. The agent wants to know if you are keeping a decent set of books which tie out to your bank accounts and reflect your current lifestyle. To the IRS, a lack of internal controls signifies a potentially inaccurate reporting of income. Not having books or decent records is a major red flag. The auditor will dig in, possibly expanding the audit to cover every line item on the tax return or to include other open tax years. That can get expensive-- not to mention stressful.
Tip No. 1: Maintain your books and records on computerized software and reconcile your bank accounts.
Auditors are trained to detect unreported bartering income. Remember that even if no money changes hands, you are required to report all bartering income, and the IRS knows this is an area of high noncompliance. It’s a tough economic climate right now, and many entrepreneurs turn to bartering to help protect cash flow.
Agents know to look for Forms 1099-B filed with the IRS, which report barter income, and they will look around your place of business for stickers or plaques that announce your participation in a bartering exchange club. They will check your website to see if you’ve listed a bartering exchange organization. While examining your books, agents will look for fees paid to bartering exchanges. And of course, an agent will straight up ask about your participation in bartering activities. Tell the truth, and take the knocks if you must. Remember, the agency has ways of finding out.
Tip No. 2: Make it a matter of course to record all bartering activity in your books at its fair market value.
Assigning income to other parties—such as another business that you own to reduce net operating losses in that company and avoid self-employment and income tax on the income can be a hairy issue. If the auditor goes through your contracts and finds one that appears to be unfulfilled (because the income was shifted), be ready to provide copies of tax returns for your other businesses for examination. Do I hear the popping sound of the can of worms being opened?
In the case of Lucas v. Earl, U.S.T.C. 496 (1930), the Supreme Court ruled that income is taxable to the one who earns it regardless of the fact that he may enter into a legally-binding agreement to have it paid to another.
Tip No.3: Don’t play games with the money. Keep your businesses separate from each other and record all income and expenses accordingly.
When looking at bank statements, an auditor will add up all the bank deposits for the year and compare them to your reported sales. If there is a discrepancy, the agent will want an explanation. Amounts deposited that exceed the amounts reported on a tax return will raise eyebrows, but there may be plausible explanations. You may have transferred personal funds into the business account to remedy a cash flow problem, or there may be deposits of other nontaxable income such as loan proceeds, or a cash gift from mom and dad.
Tip No. 4: Make sure you have an audit trail for all funds deposited to bank accounts that are not taxable income. Keep copies of cancelled checks of monies deposited with your bank statements to identify any transactions that do not represent sales.
When examining your income stream, the auditor will consider the doctrine of “Substance over Form.” In the case of Commissioner v. Court Holding Co., 324 U.S. 331 (1945) C.B. 58 it states, “How a transaction is taxed depends upon its substance. A transaction must be viewed as a whole, and each step from the beginning of negations to final consummation is relevant. The true nature of a transaction cannot be disguised by a mere outward appearance that exists solely to alter tax liabilities.”
Tip No. 5 – This again is an admonition to not play games with money. Every transaction you enter into should be for a purpose other than just making the tax code work to your benefit.
This article is the first of a 6-part series dealing with IRS audit techniques. Look out for – audit techniques for travel, meals, and entertainment next week.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitterat BLTaxpertise and at Facebook.