An Internal Revenue Service audit can be costly, time-consuming, and stressful, even if your business is found to be acting appropriately. Avoiding a tax audit altogether is preferable. While it’s impossible to determine what might get the IRS’s attention, there are several situations that investigators could find suspicious. It goes without saying that you should pay taxes in accordance with the law. Trying to walk the line between legitimate and illegal behavior can bring severe consequences that will likely outweigh the benefits of any tax scheme. Here are 5 financial scenarios that you should be prepared to justify if they apply to your business tax returns.
Keep the IRS at bay by avoiding suspicious tax details like these Tweet This
Unusually Large Business Expenses
Most small business owners can legitimately claim several money-saving deductions each year. According to the IRS, only ordinary and necessary business expenses are tax-deductible. For example, someone who runs a maid service may be able to deduct the cost of a $200 vacuum purchased solely for the business’s use. That won’t usually seem suspicious or excessive. On the other hand, trying to deduct the cost of a $750 leather jacket embroidered with the company’s name may raise eyebrows at the IRS.
Costly Entertainment Deductions
Claiming a business tax deduction for expenses incurred while entertaining clients or prospects is perfectly legal – to an extent. According to the IRS, 50% of reasonable entertainment costs can usually be deducted from your taxes. There are two qualifications. First, you cannot have been reimbursed for the expense. Second, lavish or extravagant expenses are not tax-deductible. This is similar to the “ordinary and necessary” language about business expenses. You must use your best judgment to determine whether or not the business’s entertainment expenses were typical or out of the ordinary. This can vary by business size and industry.
For example, seeking a deduction for a sunset cruise meant to entertain clients may not be lavish for a Fortune 500 company. However, the IRS might take notice if a small muffler shop did the same, then tried to deduct 50% of costs. When in doubt, ask your accountant for his or her professional opinion.
Big Changes in Income
A wildly fluctuating income may get the attention of tax authorities. If you claim substantially lower profits from one year to the next, they might wonder if you’re under-reporting your income in an effort to dodge your tax responsibility. On the other side of the coin, big gains in income can also trigger an audit.
In business, some years are better than others. Your fortunes may have changed in a brief period of time. The key is to be honest on your returns and keep records of profits and losses, just in case the IRS has questions.
Limited Cash Transactions
Credit-card processors are required to send the IRS a record of your sales each year, which the agency compares to industry norms in order to estimate the amount of cash you should be taking in. If you report a substantially lower value of cash transactions, the business may be viewed with suspicion.
Times are definitely changing when it comes to payments, with mobile phones being turned into point-of-sale terminals. Credit and debit cards are ubiquitous, so the accuracy of the IRS’s calculations can be debated. Keeping itemized receipts of cash transactions could help minimize risk if the IRS should send a letter challenging your tax return.
Large Charitable Donations
Charitable giving is a noble activity for any small business owner to undertake, but this is a case where a few bad apples have spoiled the IRS’s impression of the rest of us. Since charitable donations can lower taxable income, the IRS wants to ensure goods or money are being given to a legitimate organization. Simple cash donations to qualifying charities, where you don’t receive anything in return, can usually be deducted in full.
If you donate goods in your business’s name, make sure to deduct only their fair market value on your taxes. While you may have paid $500 for a TV in 2004, it’s likely worth far less today. What do you think a reasonable person would pay for the item? It’s possible that while your donation may be useful to a charity, it isn’t worth very much money. Keep in mind that if you contribute more than $500 worth of non-cash donations, you’ll need to file Form 8283 to account for them.
You shouldn’t avoid proper deductions out of fear that they’ll trip an alarm with the IRS. The key is making sure you can substantiate the claims being made.
If you’re wondering how you can manage risk for your business across the board, check out our guide.
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