In this article, I would like to discuss audit "red flags" to be aware of in addition to your business structure; should it be something other than a sole proprietorship?
Are you aware of audit "red flags"?
IRS audits are no fun. Being prepared in case of an audit is the best defense. There's a reason that the IRS audits sole proprietorships (see below for more information) more than other types of business entities by a margin of about 10 to 1. The IRS feels that sole proprietors keep messier books. They comingle their business and personal funds, overstate expenses, undertstate sales, and don't have records to backup any deductions they take.
Here are a few things to be vigilant about in your business, no matter what kind of business structure you operate under:
1. Keep a separate checking account and credit card for your business. Avoid using personal checks and credit cards for business expenses as much as possible.
2. When you purchase business items in your personal account, keep detailed records. This type of entry can easily be done in QuickBooks. If you don't have QuickBooks, an excel spreadsheet works well.
3. When you purchase personal items from your business, same rules. Keep records. These are not tax deductible items and are considered draws out of your business funds.
4. Keep files of receipts/bills and sales information that back up all of the income and expenses for your business. You want to take all the business deductions you are allowed on your tax return.
5. Have you hired help? If you are paying people as independent contractors, are they really employees? The IRS has a 20 part test to determine whether a contractor is really an employee. Basically, if you have control over a contractor's time, where they work, and what they work on….they may be considered an employee by the IRS. If a contractor is later determined by the IRS to be an employee, you could have a large tax bill looming due to unpaid payroll and unemployment taxes.
6. Excessive deductions. Are you having too much fun in your business? For instance, if you just started your business this year, made $10,000 in sales, and are claiming $12,000 as deductible conference and travel expenses; watch out. Take reasonable deductions on your tax return.
7. What NAISB code is your business in? The IRS uses this as a reasonableness factor when looking at your business vs others in your industry. Make sure you pick the right one!
-Pick the Right Business Structure
Many small businesses start out as sole proprietorships. It's easy; you just say that you're in business, get a DBA (doing business as), open a business checking account, and start offering your products and services. At the end of the year, you use the Schedule C attached to your 1040 income tax return to list out all of your business income and all of your business expenses. The net income or loss gets added to or subtracted from your other taxable income on your 1040.
There are two reasons you want to be a business structure OTHER than a sole proprietorship:
1. Liability protection
2. Tax savings
I won't go into a lot of detail here, but when you're a sole proprietor and something happens in your business that causes a lawsuit, your business AND personal assets are at risk. There are several business structures that provide a barrier between your business and personal assets:
1. LLC
2. Sub S Corporation
3. C Corporation
At least consider becoming an LLC (Limited Liability Company). You'll get liability protection as well as some tax benefits, depending on how your business chooses to be taxed. A Sub S Corporation and a C Corporation can be beneficial in different ways, depending on your unique situation.
It's important that you understand what each business structure is about. After you do some research for yourself, I suggest finding a CPA or attorney who specializes in business structures. They will help you determine, for your unique situation, which one would be best for you.