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Preparing For Taxes

How to File an Audit-Proof Tax Return

Most of us associate February with Valentine’s Day flowers, Ground Hog’s Day, or maybe even the birthday month of Abraham Lincoln.  But for all of us who are also small business owners it is time to start thinking about that dreaded tax return.  And worst of all is the thought that what if that tax return gets audited.  It’s a random Saturday morning and the weather is nice.  You walk out to the mailbox with your fresh morning coffee almost skipping with a song in your step.  Life is good.  But then a big white envelope appears with the return address reading…Internal Revenue Service.  Suddenly, the Saturday is not so bright and the coffee is not so fresh.

The IRS will examine approximately 1,500,000 tax returns out of approximately 150,000,000 that will be filed this year.  That basically means that the chances of your tax return being selected for review are about one percent or one out of one hundred.  If you file a Schedule C, Profit or Loss from Business meaning you are a sole proprietor your chances double to about two percent…and if you report over $100,000 in gross revenue on that Schedule C, your chances double again to about four percent.  This may seem unfair at first, but keep in mind that your return has more forms, more complexities, more calculation and therefore more potential mistakes.  The IRS certainly has endless amounts of detail about how taxpayers make mistakes on their tax returns and the examination process is designed to find those mistakes and correct them.  Since we as small business owners have more chances to make mistakes we also have more chances of getting that ugly envelope on Saturday morning.

There isn’t much we can do about the statistics of the audit process or about our chances of being included in that process but we can definitely take steps to make that process much less stressful.  The best answer to reducing that stress is to find a way to prepare an audit proof tax return.  And the time is now!  Follow the five steps below as you approach the filing of your tax return this year and you will have an audit proof tax return.

1. Plan Your Attack
2. Get The Paper
3. Report All Income
4. Build Separate Support For Each Deduction
5. Avoid Short Cuts

Before we get to the specifics of each step, I want to give you a head start on your first audit by giving you the first question that you will be asked.  The first question is always the same for ALL small business owners so once you read the next few sentences; you will always have correct answer to that first question.  May I see your business bank statements?  That’s it.  That will be your first question.  If you can answer that question with a cordial, “Yes, you may,” and then produce those monthly, neat, reconciled business bank statements a vast majority of all questions in the mind of the auditor will be answered.  This is very important.  If you haven’t opened a separate bank account for your business, as soon as you finish reading this article, go down to your bank and open that account.  And from today forward, never mix business and personal within the same bank account.  This may very well be the most important factor in preparing audit proof tax returns.

1. Plan Your Attack
Before you do one calculation or make one copy or take one single Advil, stop and think about how you are going to attack this year’s tax return.  There are basically two distinct paths for you to take.  You can prepare the tax return yourself or you can hire a professional to do the tax return for you.  Neither option is always best but it is a great idea to decide this first.  Don’t allow yourself to go through the angst of paper and software and headaches only to end up hiring someone on April 15^th to save the day.   It is my concerted opinion that most small business owners are fully capable of preparing their own return.  This is especially true with today’s technology and the help of software packages such as TurboTax, TaxAct, and even H&RBlock Tax Software.  If you expect a particularly complicated year, maybe your first year as a small business owner, or maybe you have some accelerated depreciation options because you acquire a large amount of equipment this year, then this year might be a good year to consider using a professional.  If on the other hand, this year is basically the same as last you, you might choose this year to do it yourself.  The key point is to decide now which way to go.  You might be about to save $300 to $500 or more by doing the return yourself but make sure to consider the time you will spend and make the best decision for your situation, but make that decision first.

2. Get The Paper
The reports that you have probably heard about the world moving toward a paperless society have not yet reached the Internal Revenue Service.  The preparation and the support of your tax return are still largely based on a stack of paper.  You most likely have already received a W-2 from your job, 1099s for your business, 1098s, 1099INTs, 5498s, brokerage statements, church giving statements, and on and on and on.  Each of those pieces of paper will provide a needed number for the return but also the undisputed support for that return if the IRS comes calling with questions.   Use last year’s tax return as a “To-do” list.  If you had a deduction or income item last year, you most likely will have that same number again, and now is the time to acquire its supporting piece of paper.  As non-technology friendly as it sounds, each number on your tax return should have a piece of paper that supports that number.  Don’t wait for the IRS to ask for the support since most likely they won’t ask for that piece of paper for several years.  Now is the time to get the paper so make sure you build you own personal little paper fort and you will be glad you did.

3. Report All Income
The classic textbook tax advice is to always include all income on your return and then do everything you can, via deductions and credits to get that income back off of the return.  The key for this step is to make sure you include ALL income.  Don’t forget to include all business income and not just the income reported to your on Forms 1099.  All income that you generate in the course of your business activity will be taxable income and should be included.  Don’t forget to include any and all cash payments you received as well as any income in the form of exchange of services.  If you provide your business services to repair my car in exchange for me preparing your tax return we both have taxable income to the extent of the value we received.  Always remember that intestinally excluding income from your tax return is the “F” word for the IRS, and that is Fraud.   Never, ever, exclude income.  Certainly be aggressive on the deduction side and make sure you use all available benefits, but never exclude income.

4. Build Separate Support for Each Deduction
This step could very well be an entire book and actually is the basis for many books and certainly the most important step in preparing your audit proof tax return.  A vast majority of all questions that you are likely to get from the IRS will concern the deductions that you include on your return.  Make sure that every number you include as a deduction has its own little stack of paper in support.  While you are calculating, summarizing, estimating, or just making copies for your tax preparer take the time to “prove” your number.  Easy examples include actual purchases such as office supplies, computer equipment, office rent, etc.  These items can be supported by actual receipts, entries on your credit card statement or bank statement.  Make some copies.  Use your highlighter.  Check the math.  This may seem totally cumbersome but regardless of whether you use automated accounting software such as QuickBooks or Peachtree take the time to support each of your numbers.  The paper exists, take the time to make the copies and build a separate support stack for each number.

Try and visualize a new game show called Prove It.  Maybe Steve Harvey is the host and he calls you from the audience and says, “Your tax return shows $3,415 in advertising expense…” he pauses for drama and points at you and says, “Prove It!”   If you can prove the expense with some type of third party support you win $10,000.  Ask yourself what you would like to be able to show him.  If you can answer that for each number on your tax return, you truly will have an audit proof tax return.  When you have completed this task you will already have the answer to any question that could be asked.  Don’t forget that the audit doesn’t happen on April 16th right after your file your return on April 15^th.  Instead, the audit is two and one half years later.  You won’t remember why you chose 9,000 business miles for your car and maybe you won’t even have the same laptop that you bought and deducted this year.  So NOW is the time to support your numbers.  Build your support.  Make the copies.  Take the time to Prove It now and if you get that letter two years from now, you will be so glad you did.

5. Avoid Shortcuts
As you build the support for your audit proof tax return you will be tempted to take short cuts.  You will be tempted to say things like, “Well, I have $1,200 in cell phone bills last year, let’s just use that same number again.”   Avoid those temptations and avoid those shortcuts.  Take the time to download your cell phone bills.  Make the copies.  Add them up.  It’s easy to do and the information is readily available.  Unlike two and one half years from now when you may not be able to find the right detail.  Invest the time.  Avoid shortcuts.

If you can follow these five easy steps you will have an audit proof tax return.  The cost is your time and the commitment to get all of the test questions correct.  You have the detail, you have the ability, and it only takes that commitment.  And you will never have to worry about that big white envelope ruining your Saturday morning coffee.