The IRS has undergone some profound changes. One is that they are now completely computer oriented. They are able to track most, if not all, of your income, your withholdings, and your tax history. Most of their audits occur when the information contained in a person’s tax returns does not match up with the information the IRS has on file. A more recent change is the budget cuts forced on them by Congress. This affects you because there are fewer people to answer the phones and give you help. Would it surprise you to know that even tax professionals have difficulty getting the IRS to answer a phone call? This means that most audits are done completely by mail. Communication with the IRS in a timely way by mail has become extremely important. Anybody can be audited. Never ignore a letter from the IRS.
The IRS makes mistakes. They lose information. Sometimes something in a taxpayer’s return raises a red flag and they decide to investigate. Many times they just get it wrong. These mistakes can be corrected during the audit process. The very worst thing you can do is ignore letters from the IRS. Open the letter and then bring it to me if you need help. I am your representative before the IRS!
Red Flags! Schedule C businesses, which are the type that I serve, are the most highly audited of all businesses. They are most prone to have mistakes in their tax preparation. Some of the mistakes people make that catch the eye of the IRS computers are • trying to disguise expensive personal purchases, such as autos or boats, as business deductions • not reporting all income • exaggerating expenses • having a business profile which does not match up with similar businesses in the IRS data base.
Most of tax law is set by Congress. Although some is set by the other branches of government, most is set by congress. The IRS interprets and administers these tax laws. If you don’t like their interpretation of what you owe, and you can’t get satisfaction using the means available within the IRS system, there are options available to you. There is an appeal agency which operates independently from the IRS, and there is always the U. S. Tax Court. Most of you will not have these kinds of issues and will be able to resolve your audit issues by mail.
The 4 types of audit are
• correspondence audit - the most common type. It requests more information about a part of your tax return. You will be required to substantiate the income and deductions in question.
• office audit - a more serious audit during which you will be asked specific questions requiring specific answers. These usually are done in a day but if more questions are asked you will be given time to prepare your papers.
• field audit - the most serious audit. You will be visited at your home or business by an IRS field agent. You should have representation because they are looking for something.
• random audit - the IRS examines a return randomly, with no particular area of focus. It is designed to keep you on your toes. The best solution is for you to keep good books, save all your receipts, and file an accurate return.
It is important to know the mind of the IRS when it comes to organizing your business and submitting your taxes.
There are few tax benefits from having a hobby, but a profitable business allows a great many tax benefits. These include • deductions for business use of the home • the deduction of "ordinary and necessary" business expenses • you can claim a business loss • the deduction of some start-up and organizational costs • some mileage, meal and entertainment deductions.
If you have decided to go to work for yourself, or have a profitable hobby and would like to increase your deductions, there are procedures you must follow. What the IRS wants to see is a steady and consistant profit motive. The following eight items are are strong indicators of a profit motive although not all required of every company. As your Enrolled Agent I would want to discuss your business ideas to determine the best way for you to proceed.
1) Does the time and effort put into the activity indicate an intention to make a profit?
2) Does the taxpayer depend on income from the activity? A dependency on this source of income is an indicator of a good profit motive.
3) If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
4) Has the taxpayer changed methods of operation to improve profitability?
5) Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
6) Has the taxpayer made a profit in similar activities in the past?
7) Does the activity make a profit in some years?
8) Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?
If you begin a business without plannning for its success you cannot expect it to make money. The IRS wants to see a profit three of the last five years for most businesses, so it is in your best interest to constantly improve it, keep good records, and show an increasing knowledge of the type of business you are operating. A business which does not meet this criteria stands the chance of being declared a hobby by the IRS. If this happens many of your tax benefits will be lost and you may end up owing back taxes.
There are two basic accounting methods, and a third which is a combination of the first two.
The cash method is the most common and is acceptable to most of the businesses I serve. Income and expenses are entered when they happen.
The accrual method enters income and expenses when they are incurred rather than when the transaction actually takes place. For instance, you might complete a contract and yet not be paid until some time later. The income is recorded when you finish the work, not when you are actually paid. It is similar with expenses. They are recorded when they are incurred, not when they are actually paid. This method of accounting is used when financial reports are required by financial institutions who have an interest in your business. It is also required if you keep an inventory and have gross receipts over one million dollar and are prohibited from using cash accounting.
The hybrid method combines the cash and accrual methods.
I use Quickbooks for my bookkeeping. It is very accurate and fast and is used by nearly 95% of bookkeepers. However, I can use a spreadsheet if that is your preference. Setting up the books with a logical chart of accounts allows a straightforward transfer of income and expenses to your Schedule C. I can set up your books with a minimum of fuss.
You must keep records of income and epenses to justify the entires in your books. The IRS is very specific about the types of records it accepts, and how long you have to keep them. In case of an audit if you do not have proof they will discredit your deduction. Part of our discussions will include proper recordkeeping.