As a self-employed business owner, there are a lot of risks that you take in order to be successful. Unfortunately, that success also can come with some enhanced scrutiny from the IRS. In the eyes of the IRS, individuals who are business owners, whether it’s a one-person shop or they have teams of contractors or employees that they’ve hired, have a higher chance of committing tax fraud than others. The taxes associated with being self-employed (or the boss) can seem steep compared to being an employee and the IRS has been a first-hand witness of those who have been tempted to take excessive and unsavory measures to lessen their tax liability. Fortunately, there are some simple steps you, a legally empowered business, can take to protect yourself in the event that the IRS ever takes a second look at your submissions.
No matter what form your business takes, it is important to always keep your business and personal expenses in seperate accounts. This means that when you go to pay yourself as the owner (technically referred to as an owner’s distribution) you make the transfer from your business account to your personal account before you go shopping or pay the bills. It may seem easier to keep everything in one account, especially as you’re starting out, but when it comes time to report your business income and expenses, having a separate business account will make the process a lot easier and will help preserve any liability shield stemming from your entity selection (e.g. an LLC).
Report all of your income. This one should be obvious, but all of your income, cash included, should be reported to the IRS. If the agency suspects you are withholding income information, it could open you up to an audit. Small businesses that deal primarily in cash transactions are particularly vulnerable. The IRS sees these businesses as more susceptible to ‘skimming’ and potentially underreporting their income. So the bottom line is that you need to report all of your income (per § 61 of the Internal Revenue Code). Also be sure to keep all of your sales and expense receipts so that you can support everything you report in the event you ever need to.
Be careful with deductions and expenses. Again, this one should be obvious, but make sure that you can support each expense as a business expense and not a personal one. Make sure that you are not claiming a deduction for an item you did not have to pay for. This shouldn’t discourage you from claiming your legitimate business expenses. In fact, the IRS requires you to claim all of your expenses, but don’t try to pass off your data overages from streaming Netflix on your phone as a business expense.
If you are required to, make sure you are remitting the correct payroll tax deposits when they are due. As an employer, this is one of your most important obligations and there are significant penalties for making late payroll tax deposits. Missing payroll tax deposits can bring unwanted attention to your business. If you’re having trouble staying on top of them, there are services available to automate the process and help you stay in compliance.
These four tips are just a starting point. What you need to do to ensure your business is as audit-proof as possible is going to depend on your individual circumstances. For example, if you have employees, make sure that they are classified properly. Whether those who work for you are employees or independent contractors changes your responsibilities come tax time. You will also want to be prepared for anything on your return that is a red flag to the IRS, such as large ‘entertainment’ business expenses, writing off all or the majority of your only automobile as business expenses, or appearing to be living outside of your means and claiming items that are typically personal living expenses as business or home office expenses. That is not to say that these items will get you audited, but if these are legitimate expenses it will be crucial to be able to support them with receipts and documentation in the case of an audit.
The bottom line here is that you need to be proactive about managing your business situation and taking steps to minimize your audit risks. Don’t play fast and loose when it comes to your business. Just because the risks of an audit may be low is not a permission slip to disregard the law. Trust me, no one wants to be on the receiving end of an inquiry letter from the IRS.