So I created an LLC and haven’t looked back. I’m no expert on small business taxes (in fact, I’m sure there are plenty of deductions I am still missing) but I’ve learned quite a bit about what can get you into trouble and how you can go about avoiding unnecessary audits.
In this article, I’ll lay out how you can stay out of trouble with the IRS at tax time, as well as how you can set yourself up for tax success by making the right business-related tax moves.Deal of the Day: Credit Karma Tax offers 100% free Federal and State tax filing with a Maximum Refund Guarantee and Audit Defense. Never pay a penny to file your income taxes. Read the Full Review Here
How You Can Get into Trouble with the IRS
There are plenty of ways you can get yourself into trouble with the IRS as a small business owner. Here are some of the most common ways you can find yourself seeing penalties or audits:
Under-Reporting Your Business Income
Keep away from under-reporting your business income–all business income has to be reported. This condition includes earnings from barter transactions and cash transactions. Deposits of $10,000 or more must also be reported to the IRS. Some companies attempt to prevent problems with payroll taxes by paying employees in cash, too.
Over-Reporting Your Business Expenses
Also, you will need to prevent over-reporting expenses. For example, reporting private travel expenses as business expenses, like taking a partner on a business trip and asserting that the partner’s expenses are business expenses, or reporting individual personal miles as business miles.
Evading Taxes (Instead of Avoiding Them Legally)
Tax avoidance is legal; it is done when taxpayers would like to avoid paying more tax than required. You can prevent personal and business taxes by taking credits and deductions. Provided that records support these credits and deductions and within both IRS and state regulations, you’re avoiding, not evading taxes. You might even prevent paying more than required by utilizing IRAs, 401ks, and other tax-deferral procedures.
Tax evasion, on the other hand, is when you avoid taxes by illegal procedures. “Willful” tax evasion could be intentionally doing something (such as paying in cash) or purposely omitting something (like failing to add earnings or failing to file a tax return). In the event the IRS or the Tax Court deems a tax-related act with a citizen as “willful,” it may mean fines and penalties, including jail time.
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Failing to Report Employee Taxes and Business Revenue
The most usual way that companies don’t report taxes would be the failure to report revenue taxes and payroll taxes. These taxes are called “trust fund” taxes since they’re gathered from other people such as clients in the event of sales tax and workers in the event of payroll taxes. The cash collected is kept in the trust of the company, to be paid and reported to the proper taxing authority. Willfully utilizing these taxes to finance a small business rather than reporting it and paying off when due is considered tax fraud.
Forgetting to Pay the Self-Employment Tax
Small business owners may be alarmed when calculating their tax returns for the very first time. They’ll find that they owe 15.3 percent in self-employment tax on their net self-employment income on top of their income taxes.
On the other hand, they can deduct half of the self-employment taxes to cancel out some of their earnings directly. Additionally, remember that the tax is paid only on net self-employment earnings, that is, income after expenses are deducted.
Making Necessary Quarterly Tax Payments
Small business owners do not have taxes withheld from a paycheck like conventional workers. Typically, if they expect to get a tax liability of $1,000, then they need to send tax payments to the IRS quarterly. Not understanding or knowing about quarterly estimated tax payments may lead to a considerable amount due, as well as tax penalties.
Owing More Than You Can Manage
Small business owners could end up having a yearly tax bill that seems impossible to pay. There may be several causes of this. Things like sudden earnings, defaulted installment agreements in a prior year, not paying quarterly bills, or added interest and penalties are all contributing factors.
Failing to Report Cash-Based Income
Cash-based businesses require in-depth record-keeping to substantiate expenses and income. Form 1099 may be utilized to declare income for cash-based companies, but all earnings have to be reported regardless of whether or not it’s revealed on a 1099. Every audit done by the IRS on a small business will begin with gauging whether that business reported all its earnings.
Highlighting Potential Tax Fraud Through Lifestyle Choices
Among the ways companies are caught for tax fraud would be to have a lifestyle that isn’t aligned with their reported earnings. A high-flying lifestyle suggests that company income has not been reported, ordinarily. Any small business may have a legitimate error. A company owner has a duty, though, to understand, and stick by, the legislation, or face the repercussions.
Not Tracking and Reporting Personal Expenses Appropriately
Traveling, phone, entertainment, home office, and other similar expenses are commonly deducted by small business owners to reduce their taxable earnings. However, the IRS rules about business versus personal expenditures are confusing. In reality, the IRS perceives several of these costs to be private (and therefore not allowable). This implies that good record-keeping is vital. Again, a comprehensive record-keeping method is essential.
Completely Failing to File Your Return
Some small business owners do not file because they can not cover the tax balance due, which leads to more significant tax bills and penalties. One example is a 25% “failure to file” penalty. This can be tacked onto the general tax bill if it’s five months or more overdue.
As a company owner, you have to be aware of your taxes year-round. That begins with maintaining good records during the entire year and continues with paying properly estimated tax bills to lower the tax burden at the end of the year. Finally, it culminates in submitting a precise and accurate return at the close of the year.
How to Avoid an Audit
Now that you have a sense of what types of things can get your small business into trouble with the IRS, here are some ways you can be sure to avoid a tax audit:
Create a Legal Structure Around Your Business
If you operate as a sole proprietor, the IRS will probably give your tax return more attention. So I recommend setting up a formal corporate entity, such as an LLC. Doing this can offer your business more authenticity. It also lets you claim deductions and other tax-saving steps without fear your actions will be analyzed under extra scrutiny. Just registering your business as an LLC, for example, can help lower your chance of a tax audit. I did this with my business a few years ago, and it’s made things a lot easier at tax time.
Avoid Reporting Losses Every Year
Should you report a net loss in more than two out of the most recent five years, you’re a likely candidate for a tax audit. And chances are, the IRS could decide that your company is a hobby and disallow all your small business expense deductions.
Keep Excellent Records and Report All Income and Expenses Accurately
Small business owners qualify for an extensive collection of business tax deductions. If you do not correctly claim these write-offs via documentation and receipts, your income tax return may be flagged for an audit. Plus, remember not to overstate your business expenditures. Small business accounting that is accurate can help you claim deductions and monitor all costs.
You’ll minimize your chance of an audit by keeping all small business income and expenses in a business bank account and keep your business receipts. This can make it much easier to prepare your tax return. Also, you will have everything you need to substantiate your return if you ever get audited. On the flip side, you boost your audit risk if you attempt to conceal income or subtract your expenses.
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Always Double-Check Your Numbers
Whenever someone gives you a tax form that accounts for earnings, like a 1099, they also report that data to the IRS. The IRS will anticipate the amounts in your tax return to suit what they have received from third parties. Your tax return may also bring unwanted attention in the event the numbers don’t make sense.
Mistakes are easy to make, so review any information you put in your return and check your math. Consider talking with a tax professional and having them prepare your return, or use tax planning software that is going to do the math for you.
Make Sure You Aren’t Skipping Anything on Your Tax Return
There are numerous taxes small business owners have to know about and make sure they cover in their business tax returns. Make certain every line that’s applicable to your small business tax scenario is filled out completely and accurately. Should you send in an unfinished tax return, the IRS might wonder why you didn’t disclose specific details in your return, which might cause an audit.
Make Quarterly Tax Payments If and Where Necessary
Should you expect to pay at least $500 in taxes for your small business at the end of the year, you ought to be making quarterly estimated tax payments. Failing to make these payments could result in penalties and can put you at higher risk for an audit. If you maintain proper records and are honest in your tax return, you do not need to worry about a tax audit. But if you’re unsure of the income you need to report or the deductions you are allowed to take, it’s a good idea to seek tax advice from an accountant.
Know the Rules on Independent Contractors
Firms are more likely to get audited when they have a higher ratio of independent contractors to workers. This is because utilizing independent contractors may be a means to avoid paying payroll taxes. The IRS has clear guidelines on who may be an independent contractor and who has to be classified as a worker. Ensure you understand and adhere to the rules, and if in doubt, get small business advice from a tax accountant or lawyer.
Pay Fair Salaries, but Not More
In case you’ve got a C Corp, paying your employees a higher wage could be a means to minimize earnings and lower tax premiums. Because of this, an unusually substantial salary may open your tax return up for scrutiny. Know what a fair salary range is to the business, and do not exceed it.
Be Mindful of What Constitutes a Home Office Deduction
Home offices have a lousy reputation as red flags for tax audits. Nowadays, though, you may safely choose a home office deduction if your work area legally qualifies. For many individuals, it means that your home office has to be a separate room that is used exclusively for the company. A small table against your kitchen wall won’t count. But a home office may create an audit risk if you’ve got substantial expenses for utilities or maintenance or maintain a home office and rent office space elsewhere.
Make Sure You’re Accurately Reporting All Income
Taxpayers in high-income tax brackets (especially earners of more than $200,000 per year) frequently have a more significant probability of being audited. Many small business owners fall into such high tax brackets. Whether your income comes through a small business, 1099 contract job, W-2 occupation, or through investment interest, bear in mind that all taxable income has to be reported on your return. Trying to conceal income might get you into trouble.
Submit Everything on Time
Making sure you’re following filing requirements is crucial when filing both private and business tax returns. If you don’t fulfill all applicable IRS filing deadlines, you might see late-filing penalties, interest, and maybe even a tax audit. Ask for a filing extension if you know you will not have the ability to submit your tax returns by a specific deadline. Also, don’t overlook your additional filing requirements as a business owner, for example, quarterly estimated earnings.
As you can see, business owners have a lot of flexibility and power to take a lot of tax deductions, but they’re also subject to a lot of tax-related scrutiny. If you don’t know what you’re doing, you can get yourself into a lot of trouble. When in doubt, we always recommend consulting a tax professional or lawyer, but at the very least do your taxes with a reputable service.