Selected Business Audit Issues

Introduction

My April, 2010 newsletter discussed several common-sense steps to protect against a future tax audit. This newsletter will expand on those suggestions for select activities.

Hobbies

If your activity involves yachts, horses, automobiles or sports, make sure you understand the distinction between a hobby and a business. IRS treats many business endeavors with a personal pleasure aspect as a hobby and limits the deductions to the income generated.

To avoid hobby status, develop a credible business plan that shows a profit motive, actively engage in marketing and promotion and earn a net profit in some years.

Real Estate

f you own and rent your property, you need to comprehend the passive activity loss rules and the definition of a real estate professional. Decide whether to treat each property as a separate activity or to aggregate all properties into a single activity. Maintain records of your expenses and time spent on a per-property basis.

Contractors

Contractors should record all their income and expenses in one business bank account and should refrain from making cash payments, especially to workers. Treating workers as independent contractors is an audit “red flag”, especially when nobody is treated as an employee.

As with real estate professionals, maintain income and expenses on a per-project basis and note travel, entertainment and petty cash transactions.

Day Traders

Day Traders need to grasp the “mark-to-market” rules and whether their activities qualify as a business, as opposed to investments. Investors cannot offset future investment losses with past investment gains, which can lead to a disaster.

For example, assume George traded over $100 million in year one and generated a profit of $5.0 million. In the first three weeks of year two, he lost $4.0 million. In his mind, he was still $1.0 million in the green; however, George owed $2.0 million in taxes for year one and could not offset the gains in year one with the losses in year two, so he was actually $1.0 million in the red.

Electing “mark-to-market” would have solved his problem.

S Corporations

Sole owners of an S corporation need to pay themselves a reasonable salary. IRS is targeting line seven of Form 1120S (compensation to officers) and if the amount is blank or unreasonably low, expect an audit.

In 2005, there were 1 million S corporation returns in which no officer salaries were claimed. IRS estimates that if those corporations were taxed under Schedule C (self-employed individuals), approximately $5 billion in employment taxes would have been collected.

If a single-shareholder S corporation provides services for just one company (the service recipient), IRS may reclassify the shareholder as an employee of the service recipient and disregard the S corporation.

To protect against a reclassification, the corporation should have a written independent contractor agreement with the service recipient, offer services to multiple service recipients and market and promote its availability to the public. At a minimum, the corporation should have stationery (billing invoices, letterhead, envelopes, business cards), a separate business telephone number and a website.

Conclusion

Understanding the issues and engaging in prior tax planning will go a long way to audit-proofing your company and business.

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