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10 Tips to Avoid a Tax Audit for Small Business

As Washington digs for every dollar to stem the federal deficit, IRS audits of small business tax returns are up – way up, and headed even higher.  And know this too:  Sole proprietors – the dominant type of small biz ownership – are 10 times more likely to be audited than other business entities such as LLCs, S-corps and partnerships. But here are ten tips that can help you lower your IRS audit odds:

1.       Be “DIF” score savvy. DIF is hush-hush Fed-speak for “Discriminate Information Function,” the secret IRS formula that decides if you’ll be audited. While DIF details are, well, secret, the steps below can help you avoid the audit hook. Each choice you make – including how to file (e-file or paper), when to file (early? last minute? extend?) and what deductions to claim (home office? entertainment?) – impacts your DIF score and your audit odds.

2.       Be accurate, thorough, neat and on-time (but not early). Sloppy returns, math errors and rounded numbers raise red flags at the Internal Revenue Service.  Having an accountant prepare your taxes, or using a tax prep service or tax prep software makes your return look professional and lowers chances of obvious errors.  But don’t be in a hurry. Filing early only gives the IRS extra time.

3.       Do not file electronically. The IRS hires temps to enter data from millions of paper returns. But they capture only about 40 percent of the info. Electronic filing gives the IRS quick and easy access to 100% of your return.  That’s why they like it so much.

4.       Explain yourself.  Avoid vague expense categories.  For example, “Miscellaneous” is a definite no-no.  If your biz is claiming unusual deductions, provide explanation or specific documentation with your return. Whatever it is, there’s probably a form for it.

5.       Make quarterly tax payments and issue 1099s, W2s and other mandatory filings on time.  Do these electronically. Late quarterly and estimated payments, non-payments and underestimated amounts draw serious IRS ire. Know the deadlines and meet them. File 1099s and W-2s using easy online tax services such as The BizBest Guide to 2011 Tax Forms and Answers has the info and links you need.

6.       Beware of your income-to-deduction ratio. Your audit odds rise if the difference between expenses and income exceeds 52 percent. But total deductions are only part of it. One large deduction can also raise flags.

7.       Inc. yourself. Sole proprietors who file a Schedule C for each business get audited most. To avoid the higher risk of sole proprietor audits, consider making your biz a corporation or limited liability company (LLC).

8.       Hire a tax pro.  If your return is complex or you are uncertain about treatment of deductions, income or other areas, don’t hesitate to bring in a CPA or other business tax pro.

9.       Take a home office deduction carefully. It’s a prime IRS target, so if you plan to take a home office tax deduction, make sure you know the rules.

10.   Get real. Every year, the IRS gets better at using high-tech means to track your business income with cooperation from companies you do business with as well as state and local agencies. And some things are just obvious. If you claim lots of expenses, but show little revenue to pay for them, the tax folks get curious., a BizBest site, has more helpful tax-saving advice.

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