Everyone wants to maximize their tax deductions and reduce what they owe the government. But remember: If you report income as a small business owner, you face a higher risk of getting audited than individuals with just payroll or investment income. That's because it's much easier for small business owners to understate their income or overstate their write-offs than it is for individual employees, who have their wages reported by their employer. Indeed, the IRS devotes the greatest share of its enforcement budget—41 percent in 2006—toward small businesses. The agency in recent years has tried to increase compliance through education and enforcement. The Schedule C, which sole proprietors use to report income, is the single most audited business form, says Jeff Collins, a tax attorney and former IRS auditor in Schaumburg, Ill.
Small business owners can save themselves grief by avoiding common tax slip-ups. One big trap some fall into: failing to pay payroll taxes. These contributions, which include the employer's half of Social Security and Medicare taxes, are due monthly, but business owners with cash-flow problems sometimes fail to pay them because they need to cover other fixed costs like wages and rent first, says Collins. Companies can avoid that temptation by hiring a payroll service to make the tax contributions along with each payday.
Some small business owners try to avoid payroll taxes entirely by classifying workers as independent contractors. That's legitimate if workers truly are independent—the distinction has less to do with the hours they work than it does with the degree of control the business owner has over them. Misclassifying workers can come back to bite businesses if the IRS determines the company should have been withholding taxes and contributing the employer's share of payroll taxes. "If you have a payroll of $100,000 and you did that, well now you've got a $15,000 bill," Collins says.
Businesses that pay workers and vendors in cash are also at risk in an audit. If a company doesn't have a paper trail to back up those costs, the deductions will be lost. Collins says this is often an issue among first-generation immigrant business owners or those who pay undocumented workers with cash. Such practices can put employees at risk as well. "If those expenses are deducted and you can't show documentation, you also jeopardize the employees. Then they become subject to the willful failure to file taxes," Collins says. Those who don't have records might be tempted to tell an auditor that they were lost in a flood or fire. But Collins says in that case, they should be prepared to produce an insurance claim—otherwise the auditor has no evidence to show that there was any damage to records.
But even though small businesses face a relatively higher risk of tax audits, Collins says business owners shouldn't worry—as long as their tax returns accurately reflect their business records, and their deductions are reasonable. And businesses shouldn't be afraid to take a legitimate deduction for fear of explaining it to an auditor. "Who cares if it's a red flag?" says Collins. "Bring the audit on."
For a look at 25 common tax slip-ups, flip through this slide show.
Tozzi covers small business for BusinessWeek.com.