Identifying Potential Risks in a New Business

Tax Professionals' Resource
May 9, 2013 — 1,283 views  
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Investing your time and money in a new business opportunity can be very exciting. But it can also be quite intimidating due to the endless number of factors you need to consider, such as employee hiring, location, quality control, and financing. In the midst of all these considerations, it is possible to forget one important factor that every business owner should be concerned about – audit risk. Individuals who own small businesses are more viable targets for audits than individuals who are employed in corporations.

This increased risk is due to a relatively straightforward reason. Employees who work for a corporation can report their salary on the tax returns that they file on a yearly basis. The only requirement for them is that the reported wages should match the wages that were reported by their employers. If this is true, the IRS does not have any reason to audit such an individual.

But when it is an individual who is running a business, there are limited resources for the IRS to cross reference the information that is reported by an individual. It is perceived that there is a bigger risk of the reported information being fraudulent, so there will be a reason to audit. This can often cause people to hesitate from undertaking a new business. But there are certain steps you can take for identifying risk and minimizing the probability of audits.

How IRS Selects a Candidate for Auditing?

A computer program examines every return filed by individuals with IRS. This program is known as Discriminant Inventory Function System. It assigns points to each tax return filed and compares that against the other returns. This number is what defines whether or not a person will be audited. Since the scoring system used by the IRS is not made public, as it could be misused, it is not known what scores lead to audits. If the score is lower there are more chances of avoiding the audit.

Lowering Audit Scores

Maintaining records is one of the prime tasks a business owner should do. This includes holding on to deposit slips, credit card slips, invoices, receipt books, and tapes of the cash register for recording business income. For expenses, owners have to make sure to save all account statements, canceled checks, invoices, payment slips for petty cash, and statements of credit cards. Along with all the expense and income tracking, business owners will also have to track details of any business assets purchased.

An important step in lowering your audit score is to avoid overlaps between business and personal funds. Using separate bank accounts and avoiding use of personal funds for business purchases is important. These expenses are likely to be disallowed by the IRS and will be classified as personal expenses. Also, businesses should keep records of all vehicle usage for business-related travel, including total miles, date, and the purpose of the trip.

Another claim that will lead to scrutiny from the IRS is claiming to have a home office. Unless it is used exclusively and regularly as a meeting and business place, avoid claiming a deduction for home office.

If you do get audited even after identifying risk and minimizing it, you have the right to defend your position. Consulting a knowledgeable tax accountant is also a good option.

Tax Professionals' Resource