Four Ways to Beat Small-Business Tax Audit

As a certified public accountant and former Internal Revenue Service agent, I know firsthand the thrills that come along with a tax audit. And more importantly, I understand the eerie feeling when the IRS determines your business owes tax money.

The IRS audits only a small percentage of tax returns. But if your business is one of the lucky few, understanding the appropriate steps to take will determine whether or not your outcome is favorable.

First, it is essential to understand how a tax return is selected for audit. There are many reasons a tax return could be chosen for an audit, including the following.

DIF scoring. Tax returns filed with the IRS are assigned a computerized score, known as a discriminant index function, or DIF, score. The higher the score, the more likely it is for the return to be selected for examination. Although the IRS does not reveal the mathematical formula, factors such as deductions that are greater than reported income can increase the DIF score.

Examination referrals. Audits of a related party can also trigger a tax audit. For example, while auditing the tax return of XYZ Corp., an agent may discover payments were made to ABC Co. As a result, the agent may check ABC's tax return to ensure these payments were reported. If the income was not reported, the agent may request an audit of the ABC return.

Document matching. In addition to DIF scoring and examination referrals, the IRS matches income reported by the payer on 1099 or W-2 forms to the payee's individual tax return to ensure the income is reported.

Following are four small-business strategies for beating an IRS audit.

1. Dispute the 'hobby loss' theory

As an IRS agent, one issue that continued to surface during audits was whether business activity was considered a hobby for tax purposes. According to the Internal Revenue Code Section 183, deductions are limited when an activity is not engaged in for profit. This is known as the "hobby loss rule."

If business losses have been disallowed due to the hobby loss rule, it is essential to prove the following.

Business profitability strategy. Did the business implement an advertising campaign? Is there a documented marketing plan? Provide the agent with information or plans that outline the business's plan to increase profitability in subsequent years.

Prior success. Provide evidence that shows the business has had profitable years in the past. If there are factors that may have contributed to recent losses, submit evidence that shows the loss is temporary due to economic downturns, a loss of a substantial client or other circumstances that may be considered temporary.

2. Claim missed deductions

Many business owners may not know it, but an audit is also a great time to submit documentation for expenses not previously claimed on the tax return. If you discover you have overlooked certain deductions, you may be able to claim them.

Mark DeBose, director at DeBoseRobinson LLC, an accounting firm in New Orleans, says, "Many taxpayers overlook common deductions, such as home office expense and business mileage. In addition, on the personal tax return, taxpayers often overlook expenses such as charitable contributions and mileage related to charity and medical. Because of these overlooked deductions, taxpayers often pay more than they are required (to pay)."

Take time to review your return under audit, or have an accounting professional review it for you. A business can deduct expenses that are ordinary and necessary in carrying out the trade or activity. This is a great time to submit documentation for overlooked deductions. Such deductions may reduce the taxpayer's liability or possibly generate an overpayment of taxes, which can offset any deficiencies determined by the IRS.

Common missed business expenses include:

Home office business deduction. If a taxpayer has a home office that is used exclusively and regularly for that purpose, the business may be able to deduct expenses related to the use of the home.

Business mileage. Businesses should keep a mileage log of business-related travel for the taxable year. The IRS allows for a standard deduction rate of 55 cents per mile traveled. Or the business can choose to deduct actual car expenses, such as insurance, repairs, gasoline and oil. Taxpayers should determine which method would provide a higher tax deduction.

Business gifts. Generally, a business may be able to deduct up to $25 per gift given during the course of a business.

For more information regarding business deductions, review IRS Publication 535, "Business Expenses."

3. Be creative in substantiating your deductions

Just because your business may not have certain documents to substantiate expenses on the tax return does not mean all is lost. Keep in mind that the IRS allows for third-party documentation, oral testimony and other forms of verification substantiating expenses.

For example, if a business lacks documentation to support business mileage reported on the tax return, consider using Google maps, clients' records and past invoices to estimate mileage traveled during the taxable year in question.

Also, if you have reported certain expenses but no longer have receipts or documentation to document these items, take time to retrieve prior bank records or credit card statements. It is also beneficial to make contact with vendors to request proof of payment

4. Get professional help

If you feel overwhelmed by the mere mention of the IRS, it may not be a bad idea to get a tax attorney, accountant or enrolled agent to fight on your behalf. That way, you can remove yourself, emotions and fears from the equation completely.

In addition, it also requires the IRS to make direct contact with the agent on your behalf. Begin by submitting Form 2848, "Power of Attorney and Declaration of Representative," to the IRS.

But before signing your name on the dotted line, take time to research the tax professional to determine whether he has the qualifications and/or experience to tackle your audit case.

Question whether he ever has represented others before the IRS and how many cases have been successful. Get a clear understanding of the fees charged for representation during an audit. And more importantly, speak with other clients to obtain an understanding of their experience with your designated tax professional.

We would like to thank Kemberley Washington, CPA and assistant dean of student programs at Dillard University in New Orleans, for her contribution.