Blood in the Water: Avoid Losing Your Business Tax Deductions and Other Benefits

One of the things that most businesses fear when they claim deductions is that the IRS will come in and audit them. In the worst-case scenario, they may lose the deductions that they claimed and be forced to repay the amount plus interest, as well as any punitive fees that the IRS sees fit to administer. It can feel rather nebulous, trying to figure out what the IRS is looking for. When you’re running a small business, you have so many different things to take care of.

With all of these different cares and concerns, it’s understandable to try to make things as simple as possible. For instance, you might not have a separate bank account for business matters, or you may decide to be imprecise in your calculations for the home office deduction. When looking for ways to keep life simple, remember that certain factors make it significantly more likely that the IRS will audit you. Make sure you watch out for these and avoid them as much as possible.

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photo credit: anieto2k

Failure to Keep Good Business Records

One of the things that makes business laws challenging, particularly in regards to taxes, is the amount of paperwork. If the IRS decides to audit you, it will be significantly easier if you actually have good business records.

You don’t actually have to submit those records to the IRS, but certain factors do make it appear that you have good records or not. For instance, the IRS expects you to show a profit for three years out of every five. They analyze this information based on Federal Tax Form Schedule C.

Be precise in this information. Remember that you should not include everything in this schedule. Instead, maintain extra records for your use that you can submit to the IRS if there is a problem. For instance, instead of submitting the mortgage refinance calculator break down for refinancing your home office, just submit the amount of interest that you have paid as well as the closing costs, which can, in most states be claimed as deductions. You want to save that actual breakdown to demonstrate why it was a valid business decision.

Appearing to Keep a Hobby Business

If you aren’t making a profit, don’t despair. Instead, use the other factors in your record keeping to demonstrate that, even though you aren’t showing a profit, you are still a serious business and not a hobby business.

A hobby business is defined as a business performed only for pleasure and moderate income, rather than with the sole purpose of making money. The IRS actually describes this as being an “activity continued with continuity and regularity, and for the primary purpose of pursuing profit.” As with many other IRS legal tests, this is a factor-based test. Even if you don’t have enough of a profit to demonstrate that you have a legitimate business, you can still prove that you have a legitimate business by demonstrating as many of the following factors as you can:

  • The manner in which you carry out all of the various business endeavors including records, practices, and general conduct
  • The expertise that your business requires and that you bring to the business
  • The manner in which you use your business assets and an evaluation of whether they gain or lose value
  • The overall success in business activities as well as recorded history of losses and profits
  • The business’s current financial status
  • The amount of pleasure you get from the activity

All of your record keeping should be focused around demonstrating how these factors are satisfied as well as the profit that you make from your business.

Failure to Keep Business Accounts Separate

One of the things that can make the IRS come down on your business even harder than a failure to show profit three out of five years comes from a failure to keep business accounts separate. Remember that you do give financial information when you pay your taxes.

If you pay your business taxes out of the same bank account that you pay your personal taxes, you may trigger a red flag unless you qualify for certain exemptions. Instead, make sure that you have a separate business account for paying all of your taxes rather than blurring the two together. It gets complicated when you are paying yourself out of corporate fund, but if you want to retain your benefits, you need to keep it clear. You may have to consult with a tax attorney or tax preparer who can assist you with the process.

In general, just make sure that you don’t merge your business and personal accounts. You can lose a lot of benefits just by being lazy in this regard.