A taxpayer received a strongly worded “second notice” that his taxes were overdue. Hastening to the collector’s office, he paid his bill, saying apologetically that he had overlooked the first notice. “Oh,” confided the collector with a smile, “we don't send out first notices. We’ve found that second notices are more effective.”

Running a small business is stressful enough without the IRS darkening your doorway. The bad news is that IRS audit activity continues at a record pace, especially for Schedule C filers (sole proprietors) with incomes greater than $100,000. The good news is that we do know, to a degree, how the IRS operates — the industries it targets, the red flags it looks for and the documentation it requires.

Avoiding IRS Hot Buttons

According to accounting professionals, most businesses get into trouble by pushing one or more of these IRS hot buttons:

  • Taking improper business deductions
  • Overstating or understating company officer salaries
  • Not filing employee payroll tax forms or failing to submit employee payroll taxes
  • Misclassifying employees as independent contractors
  • Operating in an industry with a known high rate of tax problems (e.g., restaurants and
    construction) or in a region with a high rate of noncompliance (Nevada has been targeted in the past).

Put on Some Armor

Fortunately, understanding basic tax rules and using sound business practices can go a long way toward keeping the IRS at bay. Consider these strategies:

Account for all income

The IRS already has an idea of your business income — they‘re just waiting to see if your numbers match theirs. It’s called “document matching,” and if the figures don’t agree, someone is going to “eyeball” your tax return.
Action: Use figures from information returns (e.g., W-2s, 1099s) when reporting income, expenses and other items that have been reported to you (and to the IRS).

Track the cash

Plain and simple, the IRS is suspicious of cash-heavy businesses — bars, restaurants, laundromats, etc. So, keep thorough records of all cash transactions.
Action: Consider using software to keep daily records of cash transactions. And, of course, report each cash payment over $10,000 using Form 8300 as required by law.

Get it right with contractors

Employers who misclassify employees as contractors are a favorite target of auditors. Also be aware of special rules governing so-called “statutory employees” (independent contractors who must be treated as employees when they fall under certain categories and conditions).
Action: Visit the IRS website (www.irs.gov) and review the “Small Business/Self-Employed Topics” section. Here, you’ll find information on how to correctly classify someone as an employee or independent contractor.

Don’t play around with payroll

The IRS can be merciless with business owners who fail to collect, pay and record payroll taxes. Business software such as QuickBooks can help automate the payroll deduction process.
Action: The IRS website also includes guidelines for employee taxes, as well as a checklist of employee records you’ll need to maintain. If you’re feeling overwhelmed by payroll duties, consider using a payroll service that will make sure all your paperwork is filed correctly.

Watch the T&E

Pay special attention to recordkeeping for travel and entertainment costs, which are common audit targets. In fact, the IRS holds business owners to higher record-keeping standards for this deduction.
Action: Review travel and entertainment substantiation requirements in IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses, available at www.irs.gov.

Peek at the playbook

The IRS trains examiners using industry-specific Audit Techniques Guides (ATGs). These eye-opening guides show what the IRS looks for and the techniques it uses to investigate specific businesses — ranging from child care providers and pizzerias to construction contractors and veterinarians.
Action: Check the IRS website to see if the IRS has a guide for your type of business.

Check your anti-audit defenses

At least once a year, sit down with your accountant and check your IRS compliance. During tax season is a natural time, allowing you to make any adjustments before filing.