While U.S. business taxation rates seem to be the largest for developed countries, these rates are often masked by the numerous tax benefits and write-offs allowed to U.S. business entities. Even though savvy business owners can effectively lighten their tax burden by deducting many business expenses, the government knows that there are some who take frivolous expense deductions thinking that there will not be any consequences.
This could not be more incorrect, as the IRS has a large enforcement effort dedicated to seeking out these deductions and scrutinizing their eligibility. If you have any of these 6 deductions listed on your tax return, be ready to defend them should you find yourself under IRS or state audit.
If you meet the requirements for an area of your home that’s used regularly and exclusively for business, you can deduct some of your household expenses (insurance, utilities, etc.) based on the fraction of your exclusive business home use. In addition, you can fully deduct expenses that are directly linked to your business and aren’t shared throughout the remainder of your home for personal use. Regular abuse of this deduction has led to increased IRS scrutiny. You must be able to document your space used for your home office, its specific business use, and prove all deducted expenses are exclusively used for business.
2. Meals and Entertainment
Business dinners, for example, are routinely brought up in an audit. Taxpayers must be able to prove that any meal written off as a business expense consisted of actions or conversations relating to their business. Since many cannot, this issue is an easy target for the IRS.
It is essential to log your business meals and entertainment meetings by identifying the following information: date of event, total cost, description (i.e. meeting with Mr. Smith to review Anderson contract), and who specifically you meet with.
3. Independent Contractors
The use of too many independent contractors for your business can attract attention from IRS, California EDD, the U.S. Department of Labor, and other payroll tax agencies. Why? Because business owners who use independent contractors do not pay payroll tax and workers compensation insurance on the workers’ pay, or provide other required benefits under employee labor laws. It is important that business owners refer to the IRS 20 Factor Test to examine whether or not their workers should be classified as employees or independent contractors. However, every government agency has a different test.
4. Estimated or Rounded Numbers
While having rounded numbers might seem reconcilable in a tax return, having too many portrays an image of estimation and overall disorganization. If the IRS or other government taxation agencies believe rounded numbers indicate poor recordkeeping, they will suspect the taxpayer is not in compliance and request greater documentation during an audit to overcome the inferred lack of credibility.
5. Professional Fees Paid to Consultants without 1099s
When dealing with paid consultants and other outsourced workers, you must issue these workers a 1099 and double check the form’s instructions. There are some exceptions to this rule, including 4 types of payments businesses commonly deal with on a yearly basis:
- A payment made to a corporation, such as medical and health care payments, which do not include attorney fees;
- A payment made with you credit card (even though the creditor keeps track of this information independently, be sure to keep personal records of these payments should the government raise this issue in an audit);
- A payment made to a consultant for an amount less than $600, which is generally seen as insignificant for reporting purposes, and sometimes overlooked;
- A payment made for any product or merchandising service with a tangible work product (though some exceptions apply to this rule).
6. Disproportionate Deductions Relative to Income
While donating to charity and other common deductions might be perfectly legal from a compliance perspective, the IRS scrutinizes these deductions. If the IRS determines you do not have enough money to use for such a purpose, it can trigger an audit. Always get an appraisal for deductions with a fair market value of $5,000 or more, and keep good records of every deduction (i.e. a copy of your check payment or property appraisal).
While there are many opportunities to take deductions on a tax return, speaking to a tax professional can reduce your audit risk and ensure you are aware of your risks in reporting a transaction. Your tax preparer can assist you in providing a complete tax return, while your tax attorney can help you review your tax return and financial records to ensure you have a legitimate legal basis to claim a deduction that may be scrutinized by IRS or other tax agencies. A tax attorney can also help you minimize your risk of an audit based on issues IRS is currently auditing.
The following article is provided only for informational purposes and does not constitute legal advice or consultation. This information is not intended to create, and receipt of this information, does not constitute an attorney-client relationship. The reader should not rely or act upon any information in this site without seeking professional legal counsel. Every case poses a unique set of facts, legal issues, and legal authority, which can and will vary the outcome of your case. If you have a legal question or need legal advice, you should contact an attorney to discuss your matter and review the unique facts of your case.