Small Business / Taxes

Shelter your Small Business from Tax Audits

There’s a way to audit-proof your business–almost. The IRS won’t tell you this, but you can avoid many tax tangles by setting up your business as a partnership or an S corporation, rather than as a sole proprietorship.

Sole proprietors are prime IRS audit targets. According to the latest statistics, more than 4% of taxpayers filing Schedule C (Form 1040) returns get audited. Compare that with less than 1% of returns for small businesses that have gone to the trouble of incorporating. Partnership returns have an audit rate of approximately 0.5%. If your spouse is active in your business, form a partnership with him/her and file a partnership return, Form 1065, US Partnership Return of Income, instead of a Schedule C. You’ll cut your audit exposure by nearly 90%. The IRS apparently does not expect big payoffs from partnership audits.

“Sole proprietors are prime IRS audit targets. According to the latest statistics, more than 4% of taxpayers filing Schedule C (Form 1040) returns get audited.”

Sole proprietors who claim home office deductions hold up two red flags for the IRS. They must file a separate home office deduction form, Form 8829, Expenses for Business Use of Your Home, and attach it to a Schedule C. Both Schedule C and Form 8829 attract IRS attention. If incorporated, however, either as an S corporation or a C (regular) corporation, you can take home office deductions without filing Form 8829. For instance, you can put the business portion of your electric bill down as a corporate expense. The same is true if you report business expenses on a partnership return. Assuming you meet the criteria for home office deductions (principal place of business, regular and exclusive use), by incorporating or forming a partnership, you can legally take these deductions without drawing attention to your return.

S corporations avoid much IRS scrutiny. One advantage is that people who pay income to the business don’t have to file Form 1099s with the IRS when they deal with an S corporation. By contrast, Schedule C filers get 1099s from anyone who pays them at least $600 in a given year. A copy of these 1099s goes to the IRS. By electing S corporation status, you’ll have fewer pieces of paper with your name on them floating around IRS files. When you do business as an S corporation, you can pay yourself a “reasonable salary”–an amount that the tax code does not clearly define. Amounts earned beyond your reasonable salary are corporate earnings. Even though corporate earnings are subject to income tax, you won’t have to pay Social Security and Medicare tax on them.

by M.E. Hansen, All rights reserved. Do not duplicate without permission

This article is for your information only. Please do not take this as tax advice – please always consult a tax professional before making any financial or filing decision. is not responsible for any actions you take regarding this information.