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Avoiding an Audit

Getting a letter in the mail saying you've been selected for an audit may be everybody's nightmare. There are ways you can decrease the risk of being audited, though, starting with how you keep your books.

When developing a bookkeeping system to record your business income and expenses, a little extra effort can help simplify tax return preparation. For example, you can tailor your system to reflect what the IRS is going to want to see on the return, saving you the time you might spend re-categorizing expenses at year's end.

The IRS doesn't require any specific type of record, with a few exceptions, such as auto, entertainment, per diem and gift expenses. What they are going to want to see in your books is your gross income, as well as details for your business deductions and credits. How you accomplish this task doesn't concern the IRS, but you need to have more than guesstimates and a shoebox full of receipts.

When the IRS receives your return, the data is statistically compared to all other returns of your type and business code. All likekind returns are combined, and deductions and income are averaged. With income used as the divisor and representing 100 percent, the lineby- line deductions on the return are calculated as a percent of income.

If your returns have deductions above the norm, you get discriminate index function (DIF) points depending on the variance between your return and the average. The IRS doesn’t give the exact method of computing these points, but the more you score, the more likely you’ll be audited.

Let’s have a look at how you can reduce your audit risk by adding subaccounts to your advertising expense category, for example. Assume your income on line 7 of your Schedule C is $20,000, and your expense for advertising, entered on line 8, is $2,000. You could use categories like the following:

Yellow pages $300
Classified ads $100
Website $800
Brochures $400
Coupons $400
Total: $2,000
If all of your advertising were included in line 8, these costs would account for 10 percent of your income. Per the latest IRS data, advertising averages approximately 3.8 percent of total income, meaning the 10 percent listed in the above example would be high enough to have DIF points affixed to the return.

To avoid the DIF points, you can use only the Yellow pages and classified ads in line 8, totaling $400. This amount equals 2 percent of income, well below the average, and you can claim the remaining three items on line 27 under other expenses. By doing this, you lower your audit risk and show the IRS that you are using several different methods to generate income.

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