4 ways to beat small-business tax audit

Calculator and pencil laying on tax forms, low light
  • Claiming missed deductions can offset deficiencies.
  • Alternative documentation helps prove your case.
  • Professional help removes emotions from the equation.

As a certified public accountant and former Internal Revenue Service agent, I know firsthand the thrills that come along with a tax audit. And more importantly, I understand the eerie feeling when the IRS determines your business owes tax money.

The IRS audits only a small percentage of tax returns. But if your business is one of the lucky few, understanding the appropriate steps to take will determine whether or not your outcome is favorable.

First, it is essential to understand how a tax return is selected for audit. There are many reasons a tax return could be chosen for an audit, including the following.

DIF scoring. Tax returns filed with the IRS are assigned a computerized score, known as a discriminant index function, or DIF, score. The higher the score, the more likely it is for the return to be selected for examination. Although the IRS does not reveal the mathematical formula, factors such as deductions that are greater than reported income can increase the DIF score.

Examination referrals. Audits of a related party can also trigger a tax audit. For example, while auditing the tax return of XYZ Corp., an agent may discover payments were made to ABC Co. As a result, the agent may check ABC's tax return to ensure these payments were reported. If the income was not reported, the agent may request an audit of the ABC return.

Document matching. In addition to DIF scoring and examination referrals, the IRS matches income reported by the payer on 1099 or W-2 forms to the payee's individual tax return to ensure the income is reported.

Following are four small-business strategies for beating an IRS audit.

1. Dispute the 'hobby loss' theory

As an IRS agent, one issue that continued to surface during audits was whether business activity was considered a hobby for tax purposes. According to the Internal Revenue Code Section 183, deductions are limited when an activity is not engaged in for profit. This is known as the "hobby loss rule."

If business losses have been disallowed due to the hobby loss rule, it is essential to prove the following.

Business profitability strategy. Did the business implement an advertising campaign? Is there a documented marketing plan? Provide the agent with information or plans that outline the business's plan to increase profitability in subsequent years.

Prior success. Provide evidence that shows the business has had profitable years in the past. If there are factors that may have contributed to recent losses, submit evidence that shows the loss is temporary due to economic downturns, a loss of a substantial client or other circumstances that may be considered temporary.

2. Claim missed deductions

Many business owners may not know it, but an audit is also a great time to submit documentation for expenses not previously claimed on the tax return. If you discover you have overlooked certain deductions, you may be able to claim them.

Mark DeBose, director at DeBoseRobinson LLC, an accounting firm in New Orleans, says, "Many taxpayers overlook common deductions, such as home office expense and business mileage. In addition, on the personal tax return, taxpayers often overlook expenses such as charitable contributions and mileage related to charity and medical. Because of these overlooked deductions, taxpayers often pay more than they are required (to pay)."


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