Four Tips to Reduce the Risk of a Tax Audit

For many business owners, tax season can be stressful. These four tips can help you lessen the chances of triggering a tax audit.

1. Cash Transfers. When the Internal Revenue Service (“Service”) audits income tax returns, it increasingly focuses on what some tax professionals refer to as “deposit account reconciliations.” For persons who own a business or businesses, a Service auditor would likely review cash transfers between the owner and the businesses and cash transfers between the businesses. A business owner, especially an owner of multiple C corporations, should be careful in documenting cash transfers between entities. The Service could reclassify improperly documented transfers as income to the receiving entity or owner. This could result in significant, adverse income consequences and result in additional taxes, penalties, and interest. Transfers between entities should be documented in accordance with the transfers’ intended purposes. For example, if the transfers are intended to be loans, there should be promissory notes with adequate stated interest as set forth in the Internal Revenue Code and Treasury regulations. Interest should be accrued and paid. Failure to do so, among other things, could result in the Service classifying transfers as nondeductible dividends with resulting income to the receiving entity. Keep in mind that many audits occur one to two years after a tax return has been filed. Additional income taxes due as a result of an audit could, as noted above, result in the assessment of significant penalties and interest that would accrue from the dates the tax returns were filed if the Service were to be successful in a reclassification.
2. Schedule C.  If you operate a business that reports its income and expenses on Schedule C of Form 1040, be aware that the Service often targets Forms 1040 with significant Schedule C items for audit. Such filers lack the formality of reporting business income via entity tax returns. In many cases, the taxpayer takes positions that are too aggressive when deducting expenses. If you operate a business that reports its income and expenses on Schedule C of your Form 1040, consider forming an S corporation or multi-member limited liability company so that you can report this income via a Schedule K-1.
3. Large Rounded Numbers. Multiple large, rounded numbers could trigger an audit. This is especially the case for tax returns that contain several such numbers. If it is a legitimate number, such as $60,000 for rent paid, then report it accurately. It is unlikely that a carefully prepared return will contain several large, rounded numbers. For any large expenses, it would be better to provide details. For example, instead of reporting a significant utility expense deduction, report such expense separately for gas, electricity, and water/sewer services. More detail is better because it indicates a carefully prepared income tax return.
4. Leases.  If you own the real estate where your business is located and pay yourself rent, you should have a written lease agreement. Otherwise, the Service could disallow deductions of such payments.

For questions about reducing the risk of a tax audit or other business-related queries, reach out to Poyner Spruill’s attorneys in the Business Section.