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Sunday, April 3, 2011

Red flags on your business tax return that may trigger an IRS audit

The U.S. Internal Revenue Service has decades of experience dealing with tax returns and in that time has developed statistical, formulaic and numerical data on higher risk tax filings in terms of potential tax evasion. The IRS has developed an audit alert warning system that is triggered by certain risk factors that correlate with information submitted and/or not submitted on tax filings. These triggers may be applied to business tax filings. Some of the "red flags" that may cause an IRS audit are as illustrated in the following financial adivsor video and the paragraphs that follow:


Business tax filing red flags


• Unreported business and/or staff income

Businesses such as restaurants and sole proprietorships may erroneously or fraudulently under-report certain forms of income leading to a lower reported taxation to the IRS. Certain types of businesses such as those mentioned above are more likely than others to report incorrect amounts and are thus at greater chance of being audited.

• Over reported expenses:

Another potential trigger for a business audit is over reporting business expenses such as automobile expenses, meal expenses, or inventory space used. Typical businesses of certain sizes generally have a 'normal' range of expenses that can be expected, however tax filings that fall outside of this range or are quantitatively unrealistic may set off an Internal Revenue Service warning algorithm.

• Inconsistency with historical tax filings

Businesses may follow various trends such as accounting methods, income growth, expense deductions, employee withholding, depreciation etc. When these trends become unrealistic the probability increases the tax filing is erroneous. For example, if a business reports depreciation of 2% every year for 5 years in a row and then reports depreciation of 7% this indicates a change in accounting methods from straight line depreciation to accelerated depreciation. Changes like this and other adjustments to accounting systems may have to be formally reported and could lead to an audit.

• Missing IRS forms

Every business, whether it be a sole proprietorship, partnership, limited liability corporation, S-Corporation or C -Corporation has certain filing requirements which include specific forms to be completed and sent to the IRS. For example, partnerships are required to file a form 1065 or U.S. Return of Partnership Income. If these forms are missing or incomplete there is a significant chance the IRS may inquire further, request more information or audit the business.

Sole proprietorship and other red flags


• Taxable income range

The greatest amount of tax filing audits occur for tax forms reporting taxable income in excess of $100,000.00. By reducing one's taxable income to under this level one is statistically reducing one's chance of being audited by approximately 45.23%. If one reports income below $50,000.00, the tax filer is reducing statistical probability of audit by around 16.89%

• Incorrect 1099 or other previously reported information

Employers and financial institutions all report data to the Internal Revenue Service independently. This means the IRS has a means of comparing one set of information with another. For example, form 1099's which are other income earned forms are reported to the IRS separately by financial institutions. Misstating the same information the IRS already knows about can trigger an audit. Other information that may be previously reported to the IRS includes interest on loans, mortgage payments, and property tax. Erroneously reporting these figures is also liable to activate a red flag with the IRS.

• Income tax deductions

Another area that is subject to triggering a potential audit is the quantitative amount of deductions made on a tax filing. If the deductions are disproportionately large or numerically inconsistent with the tax filers other financial data, the audit alert may trigger causing an audit inspection. For example, a sole proprietor may over report home office space used for inventory storage. If that proprietor has a home that is 1300 square feet and the expenses reported are for a space of 980 square feet, this may exceed the logical space for a home that can be utilized for storage as most homes require a certain amount of square footage for living space.

U.S. Internal Revenue Service audits are prompted by computer algorithms based on historical financial and tax reporting statistics. Essentially, dishonest tax reporting is recordable in the form of tax filing patterns and/or trends. Some of these patterns and trends are correlated with the red flags illustrated above and may cause an IRS tax audit. Additionally, some tax filing classes such as those within a certain type of business or taxable income range are statistically more likely to be audited than others. This is because these businesses or tax filers are either likely to generate more tax revenue for the IRS and/or have a historical likelihood of erroneously reporting tax data than other tax filing categories.

Sources:

1. http://biztaxlaw.about.com/od/businessaudits/a/audit_red_flags.htm
2. http://sbinformation.about.com/od/taxes/a/avoidsbaudit_ga.htm
3. http://www.irs.gov
4. http://www.wwwebtax.com/audits/audit_avoiding.htm