small business accounting

Essential Steps for Your Business to Prepare for and Respond to an IRS Audit

Ken Botwinick, CPA | 10/21/2024

The IRS has recently increased its audit efforts, particularly targeting large businesses and high-income individuals. By 2026, audit rates for large corporations with assets over $250 million will nearly triple, while partnerships with assets exceeding $10 million will experience a tenfold increase in audits. This surge in audit activity is fueled by the Inflation Reduction Act, with a clear focus on addressing high-dollar noncompliance and wealthier entities.

While small businesses and individuals making less than $400,000 annually are unlikely to see a significant uptick in audits, the IRS is concentrating on more complex returns. For example, one focal point includes taxpayers who use business aircraft for personal purposes—while businesses can deduct expenses for corporate planes, non-business travel isn’t tax-deductible.

How to Prepare for an IRS Audit

The best way to navigate an IRS audit is to be prepared well in advance. Here are some critical steps your business can take to safeguard itself:

Maintain Accurate Records
Keep organized documentation of all business transactions, including invoices, bills, canceled checks, and receipts. Properly maintaining these records will serve as vital proof for items reported on your tax returns.
Know Common Red Flags
Certain entries on your tax returns may trigger scrutiny. Be mindful of potential red flags such as:
- Significant inconsistencies between previous returns and your latest filing.
- Gross profit margins or expenses that differ dramatically from others in your industry.
- Miscalculations or unusually high deductions that stand out to auditors.
Pay particular attention to deductions with strict recordkeeping requirements, like auto and travel expenses. Additionally, owner-employee salaries that are out of sync with similar businesses can attract attention, especially for corporations.
Stay Proactive
Regularly review your business’s tax filings to ensure accuracy and compliance. By identifying discrepancies early, you can address issues before the IRS flags them for an audit.

How to Respond to an IRS Audit

If the IRS selects your business for an audit, you’ll be notified by letter. Contrary to some scams, the IRS does not initiate audits over the phone, email, or text message. Here’s how to handle the situation if you receive a legitimate audit notice:

Stay Calm
Many audits are routine, and not all require face-to-face meetings with an auditor. In fact, some audits may only request that you mail in supporting documentation for specific deductions.
Gather Your Documentation
Once notified, collect and organize all relevant financial records to support the information on your tax return. If some documents are missing, attempt to recreate them using other supporting evidence.
Understand the Discrepancies
The IRS will outline the specific items it is questioning. Be sure to understand exactly what is being disputed before responding.
Respond to the Audit Properly
If an in-person audit is required, ensure that all necessary documents are in order and ready to be reviewed. For mail-in audits, send the requested documentation promptly. Ignoring notices can result in further IRS actions.

How Our Firm Can Help

Facing an IRS audit can be overwhelming, but you don’t have to go through it alone. Our team can assist in:

Clarifying what the IRS is disputing (sometimes it’s not entirely clear),
Gathering the necessary documents and information to support your case,
Preparing the most effective response to the IRS inquiries.

Remember, the IRS typically has three years from the date of filing to audit your returns. By taking a proactive, organized approach to your tax filings, you can mitigate the chances of being audited in the first place and make the process more manageable if it does occur.

By implementing these best practices, your business will be well-prepared to navigate an IRS audit with confidence and minimize potential disruptions. Don’t wait until an audit happens—proactive preparation is key to safeguarding your business. If you need expert guidance or assistance with your tax documentation, our team is here to help. Contact us today to ensure your business is fully equipped to handle any IRS audit with ease.

Q&As

How can businesses prepare for an IRS audit?

To prepare for an IRS audit, businesses should maintain detailed and organized documentation of all financial activities. This includes keeping invoices, receipts, bills, and other proof of expenses in one central location. It’s also essential to be aware of common audit triggers, such as significant inconsistencies in returns, unusually high deductions, or financials that differ greatly from industry standards.

What are some red flags that might lead to an audit?

Certain tax return entries can attract IRS scrutiny, including significant differences between past returns and the most current one, gross profit margins or expenses that are out of line with other businesses in the industry, and high or miscalculated deductions. Specific deductions, like auto and travel expenses, often require strict documentation, and salary discrepancies for owner-employees in corporations may also raise red flags.

What should you do if the IRS notifies you of an audit?

If selected for an audit, the IRS will notify you by letter. It’s important to respond promptly, gather the necessary documentation, and stay calm. Many audits simply request documentation by mail, while more thorough audits may require in-person meetings. The IRS will provide time to collect all relevant records, and if anything is missing, you’ll need to reconstruct the information accurately from available sources.

How can a CPA firm help you during an IRS audit?

A CPA firm can assist by helping you understand what the IRS is disputing, gathering the specific documents and information needed to support your case, and responding effectively to the IRS’s inquiries. Having professional support can make the process more manageable and ensure that all responses are timely and accurate.

What’s The Best Accounting Method Route For Business Tax Purposes?

Ken Botwinick, CPA | 02/19/2024

Businesses basically have two accounting methods to figure their taxable income: cash and accrual. Many businesses have a choice of which method to use for tax purposes. The cash method often provides significant tax benefits for eligible businesses, though some may be better off using the accrual method. Thus, it may be prudent for your business to evaluate its method to ensure that it’s the most advantageous approach.

Eligibility to use the cash method

“Small businesses,” as defined by the tax code, are generally eligible to use either cash or accrual accounting for tax purposes. (Some businesses may also be eligible to use various hybrid approaches.) Before the Tax Cuts and Jobs Act (TCJA) took effect, the gross receipts threshold for classification as a small business varied from $1 million to $10 million depending on how a business was structured, its industry and factors involving inventory.

The TCJA simplified the small business definition by establishing a single gross receipts threshold. It also increased the threshold to $25 million (adjusted for inflation), expanding the benefits of small business status to more companies. For 2024, a small business is one whose average annual gross receipts for the three-year period ending before the 2024 tax year are $30 million or less (up from $29 million for 2023).

In addition to eligibility for the cash accounting method, small businesses can benefit from advantages including:

Simplified inventory accounting,
An exemption from the uniform capitalization rules, and
An exemption from the business interest deduction limit.

Note: Some businesses are eligible for cash accounting even if their gross receipts are above the threshold, including S corporations, partnerships without C corporation partners, farming businesses and certain personal service corporations. Tax shelters are ineligible for the cash method, regardless of size.

Difference between the methods

In contrast, accrual-basis businesses recognize income when earned and deduct expenses when incurred, without regard to the timing of cash receipts or payments. Therefore, they have little flexibility to time the recognition of income or expenses for tax purposes.

The cash method also provides cash flow benefits. Because income is taxed in the year received, it helps ensure that a business has the funds needed to pay its tax bill.

However, for some businesses, the accrual method may be preferable. For instance, if a company’s accrued income tends to be lower than its accrued expenses, the accrual method may result in lower tax liability. Other potential advantages of the accrual method include the ability to deduct year-end bonuses paid within the first 2½ months of the following tax year and the option to defer taxes on certain advance payments.

Switching methods

Even if your business would benefit by switching from the accrual method to the cash method, or vice versa, it’s important to consider the administrative costs involved in a change. For example, if your business prepares its financial statements in accordance with U.S. Generally Accepted Accounting Principles, it’s required to use the accrual method for financial reporting purposes. That doesn’t mean it can’t use the cash method for tax purposes, but it would require maintaining two sets of books.

Changing accounting methods for tax purposes also may require IRS approval. Contact us to learn more about each method.

Q&As

What are the main differences between the cash and accrual accounting methods?

The main differences between the cash and accrual accounting methods lie in how income and expenses are recorded and recognized. Under the cash accounting method, revenue is recognized when cash is received from customers, and expenses are recognized when cash is paid to suppliers or other parties. This method focuses on actual cash inflows and outflows. On the other hand, the accrual accounting method records revenue when it is earned, regardless of when payment is received, and expenses are recorded when they are incurred, regardless of when payment is made. This method matches revenues with their associated expenses, providing a more accurate picture of a company’s financial performance.

Which accounting method—cash or accrual basis—provides better tax advantages for businesses?

For most businesses, the cash method provides significant tax advantages. Because cash-basis businesses recognize income when received and deduct expenses when they’re paid, they have greater control over the timing of income and deductions. The cash method also provides cash flow benefits. Because income is taxed in the year received, it helps ensure that a business has the funds needed to pay its tax bill. However, for some businesses, the accrual method may be preferable. For instance, if a company’s accrued income tends to be lower than its accrued expenses, the accrual method may result in lower tax liability. Other potential advantages of the accrual method include the ability to deduct year-end bonuses paid within the first 2½ months of the following tax year and the option to defer taxes on certain advance payments.

What types of businesses are eligible to use the cash method for tax purposes?

Generally, businesses with average annual gross receipts of $30 million or less for the three-year period ending before the 2024 tax year are eligible to use the cash method. Some businesses are eligible for cash accounting even if their gross receipts are above the threshold, including S corporations, partnerships without C corporation partners, farming businesses and certain personal service corporations.

Can my business switch between the cash and accrual method?

Yes, businesses can switch between the cash and accrual method of accounting. However, it is important to note that once a business chooses a method for tax purposes, it generally must obtain permission from the IRS to change methods. The IRS has specific rules and procedures for changing accounting methods, and businesses should consult with a tax professional or accountant to ensure compliance with these regulations. Additionally, switching between methods may have implications for financial reporting and may require adjustments to be made to prior period financial statements. It is recommended to carefully consider the benefits and drawbacks of each method before making a decision to switch.

Tax-Favored Qualified Small Business Corporation Status Could Help You Thrive

Ken Botwinick, CPA | 01/16/2024

Operating your small business as a Qualified Small Business Corporation (QSBC) could be a tax-wise idea.

Tax-free treatment for eligible stock gains

QSBCs are the same as garden-variety C corporations for tax and legal purposes — except QSBC shareholders are potentially eligible to exclude from federal income tax 100% of their stock sale gains. That translates into a 0% federal income tax rate on QSBC stock sale profits! However, you must meet several requirements set forth in Section 1202 of the Internal Revenue Code, and not all shares meet the tax-law description of QSBC stock. Finally, there are limitations on the amount of QSBC stock sale gain that you can exclude in any one tax year (but they’re unlikely to apply).

Stock acquisition date is key

The 100% federal income tax gain exclusion is only available for sales of QSBC shares that were acquired on or after September 28, 2010.

If you currently operate as a sole proprietorship, single-member LLC treated as a sole proprietorship, partnership or multi-member LLC treated as a partnership, you’ll have to incorporate the business and issue yourself shares to attain QSBC status.

Important: The act of incorporating a business shouldn’t be taken lightly. We can help you evaluate the pros and cons of taking this step.

Here are some more rules and requirements:

Eligibility. The gain exclusion break isn’t available for QSBC shares owned by another C corporation. However, QSBC shares held by individuals, LLCs, partnerships, and S corporations are potentially eligible.
Holding period. To be eligible for the 100% stock sale gain exclusion deal, you must hold your QSBC shares for over five years. For shares that haven’t yet been issued, the 100% gain exclusion break will only be available for sales that occur sometime in 2029 or beyond.
Acquisition of shares. You must acquire the shares after August 10, 1993, and they generally must be acquired upon original issuance by the corporation or by gift or inheritance.
Businesses that aren’t eligible. The corporation must actively conduct a qualified business. Qualified businesses don’t include those rendering services in the fields of health; law; engineering; architecture; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; businesses where the principal asset is the reputation or skill of employees; banking; insurance; leasing; financing; investing; farming; production or extraction of oil, natural gas, or other minerals for which percentage depletion deductions are allowed; or the operation of a hotel, motel, restaurant, or similar business.
Asset limits. The corporation’s gross assets can’t exceed $50 million immediately after your shares are issued. If after the stock is issued, the corporation grows and exceeds the $50 million threshold, it won’t lose its QSBC status for that reason.

2017 law sweetened the deal

The Tax Cuts and Jobs Act made a flat 21% corporate federal income tax rate permanent, assuming no backtracking by Congress. So, if you own shares in a profitable QSBC and you eventually sell them when you’re eligible for the 100% gain exclusion break, the 21% corporate rate could be all the income tax that’s ever owed to Uncle Sam.

Tax incentives drive the decision

Before concluding that you can operate your business as a QSBC, consult with us. We’ve summarized the most important eligibility rules here, but there are more. The 100% federal income tax stock sale gain exclusion break and the flat 21% corporate federal income tax rate are two strong incentives for eligible small businesses to operate as QSBCs.

Choosing a Business Entity: Which Way To Go?

Ken Botwinick, CPA | 11/08/2023

If you’re planning to start a business or thinking about changing your business entity, you need to determine what will work best for you. Should you operate as a C corporation or a pass-through entity such as a sole-proprietorship, partnership, limited liability company (LLC) or S corporation? There are many issues to consider.

Currently, the corporate federal income tax is imposed at a flat 21% rate, while individual federal income tax rates currently begin at 10% and go up to 37%. The difference in rates can be alleviated by the qualified business income (QBI) deduction that’s available to eligible pass-through entity owners that are individuals, and some estates and trusts.

Individual rate caveats: The QBI deduction is scheduled to end in 2026, unless Congress acts to extend it, while the 21% corporate rate is not scheduled to expire. Also, noncorporate taxpayers with modified adjusted gross incomes above certain levels are subject to an additional 3.8% tax on net investment income.

Organizing a business as a C corporation instead of a pass-through entity may reduce the current federal income tax on the business’s income. The corporation can still pay reasonable compensation to the shareholders and pay interest on loans from the shareholders. That income will be taxed at higher individual rates, but the overall rate on the corporation’s income can be lower than if the business was operated as a pass-through entity.

More to take into account

There are other tax-related factors to take into consideration. For example:

If most of the business profits will be distributed to the owners, it may be preferable to operate the business as a pass-through entity rather than a C corporation, since the shareholders will be taxed on dividend distributions from the corporation (double taxation). In contrast, owners of a pass-through entity will only be taxed once, at the personal level, on business income. However, the impact of double taxation must be evaluated based on projected income levels for both the business and its owners.
If the value of the assets is likely to appreciate, it’s generally preferable to conduct business as a pass-through entity to avoid a corporate tax when the assets are sold or the business is liquidated. Although corporate level tax will be avoided if the corporation’s shares, rather than its assets, are sold, the buyer may insist on a lower price because the tax basis of appreciated business assets cannot be stepped up to reflect the purchase price. That can result in much lower post-purchase depreciation and amortization deductions for the buyer.
If the business is a pass-through entity, an owner’s basis in his or her interest in the entity is stepped-up by the entity income that’s allocated to the owner. That can result in less taxable gain for the owner when his or her interests in the entity are sold.
If the business is expected to incur tax losses for a while, you may want to structure it as a pass-through entity so you can deduct the losses against other income. Conversely, if you have insufficient other income or the losses aren’t usable (for example, because they’re limited by the passive loss rules), it may be preferable for the business to be a C corporation, since it’ll be able to offset future income with the losses.
If the owner of a business is subject to the alternative minimum tax (AMT), it may be preferable to organize as a C corporation, since corporations aren’t subject to the AMT. Affected individuals are subject to the AMT at 26% or 28% rates.

As you can see, there are many factors involved in operating a business as a certain type of entity. This only covers a few of them. For more details about how to proceed in your situation, consult with us.

The Advantages of Using an LLC For Your Small Business

Ken Botwinick, CPA | 08/02/2023

If you operate your small business as a sole proprietorship, you may have thought about forming a limited liability company (LLC) to protect your assets. Or maybe you’re launching a new business and want to know your options for setting it up. Here are the basics of operating as an LLC and why it might be a good choice for your business.

An LLC is a bit of a hybrid entity because it can be structured to resemble a corporation for owner liability purposes and a partnership for federal tax purposes. This duality may provide the owners with the best of both worlds.

Protecting your personal assets

Like the shareholders of a corporation, the owners of an LLC (called “members” rather than shareholders or partners) generally aren’t liable for the debts of the business except to the extent of their investment. Thus, the owners can operate the business with the security of knowing that their personal assets are protected from the entity’s creditors. This protection is much greater than that afforded by partnerships. In a partnership, the general partners are personally liable for the debts of the business. Even limited partners, if they actively participate in managing the business, can have personal liability.

Tax issues

The owners of an LLC can elect under the “check-the-box” rules to have the entity treated as a partnership for federal tax purposes. This can provide a number of benefits to the owners. For example, partnership earnings aren’t subject to an entity-level tax. Instead, they “flow through” to the owners, in proportion to the owners’ respective interests in profits, and are reported on the owners’ individual returns and taxed only once.

To the extent the income passed through to you is qualified business income, you’ll be eligible to take the Section 199A pass-through deduction, subject to various limitations. (However, keep in mind that the pass-through deduction is temporary. It’s available through 2025, unless Congress acts to extend it.)

In addition, since you’re actively managing the business, you can deduct on your individual tax return your ratable shares of any losses the business generates. This, in effect, allows you to shelter other income that you (and your spouse, if you’re married) may have.

An LLC that’s taxable as a partnership can provide special allocations of tax benefits to specific partners. This can be a notable reason for using an LLC over an S corporation (a form of business that provides tax treatment that’s similar to a partnership). Another reason for using an LLC over an S corp is that LLCs aren’t subject to the restrictions the federal tax code imposes on S corps regarding the number of owners and the types of ownership interests that may be issued.

Consider all angles

In conclusion, an LLC can give you corporate-like protection from creditors while providing the benefits of taxation as a partnership. For these reasons, you may want to consider operating your business as an LLC. Contact us to discuss in more detail how an LLC might be an appropriate choice for you and the other owners.

4 Ways Corporate Business Owners Can Help Ensure Their Compensation Is “Reasonable”

Ken Botwinick, CPA | 05/02/2023

If you’re the owner of an incorporated business, you know there’s a tax advantage to taking money out of a C corporation as compensation rather than as dividends. The reason: A corporation can deduct the salaries and bonuses that it pays executives, but not dividend payments. Therefore, if funds are paid as dividends, they’re taxed twice, once to the corporation and once to the recipient. Money paid out as compensation is only taxed once — to the employee who receives it.

However, there are limits to how much money you can take out of the corporation this way. Under tax law, compensation can be deducted only to the extent that it’s reasonable. Any unreasonable portion isn’t deductible and, if paid to a shareholder, may be taxed as if it were a dividend. Keep in mind that the IRS is generally more interested in unreasonable compensation payments made to someone “related” to a corporation, such as a shareholder-employee or a member of a shareholder’s family.

Steps to help protect yourself

There’s no simple way to determine what’s reasonable. If the IRS audits your tax return, it will examine the amount that similar companies would pay for comparable services under similar circumstances. Factors that are taken into account include the employee’s duties and the amount of time spent on those duties, as well as the employee’s skills, expertise, and compensation history. Other factors that may be reviewed are the complexities of the business and its gross and net income.

There are four steps you can take to make it more likely that the compensation you earn will be considered “reasonable,” and therefore deductible by your corporation:

Keep compensation in line with what similar businesses are paying their executives (and keep whatever evidence you can get of what others are paying to support what you pay).
In the minutes of your corporation’s board of directors’ meetings, contemporaneously document the reasons for compensation paid. For example, if compensation is being increased in the current year to make up for earlier years in which it was low, be sure that the minutes reflect this. (Ideally, the minutes for the earlier years should reflect that the compensation paid then was at a reduced rate.) Cite any executive compensation or industry studies that back up your compensation amounts.
Avoid paying compensation in direct proportion to the stock owned by the corporation’s shareholders. This looks too much like a disguised dividend and will probably be treated as such by the IRS.
If the business is profitable, pay at least some dividends. This avoids giving the impression that the corporation is trying to pay out all of its profits as compensation.

You can avoid problems and challenges by planning ahead. Contact us if you have questions or concerns about your situation.

Essential Steps for Your Business to Prepare for and Respond to an IRS Audit

How to Prepare for an IRS Audit

How to Respond to an IRS Audit

How Our Firm Can Help

Q&As

What’s The Best Accounting Method Route For Business Tax Purposes?

Q&As

Tax-Favored Qualified Small Business Corporation Status Could Help You Thrive

Choosing a Business Entity: Which Way To Go?

The Advantages of Using an LLC For Your Small Business

4 Ways Corporate Business Owners Can Help Ensure Their Compensation Is “Reasonable”

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