Defending your business against an audit

If you own or operate a small business, it’s important to note that all the rights and remedies to avoid tax collection abuse discussed in this web site also apply to small businesses. The only difference is that businesses are audited and penalized approximately six times more than individuals.

In the eyes of the IRS, businesses—especially small businesses—are the source of most of the tax cheating. The IRS’s position is that such “cheating” is due to allegedly overstating expenses and underreporting income. If there is one thing a small business owner does not need, it’s the hassle of dealing with bogus IRS claims while struggling to make a living.

The IRS is so intent on auditing and penalizing small businesses, they have developed special audit task forces to audit various business segments. For example, restaurant owners are prime targets for audit. Contractors and subcontractors (like plumbers and electricians) are also another favorite target. One of the most favorite audit targets of all is multi-level marketers such as Amway and Shaklee distributors.

The good news is, the audit-proofing and penalty-proofing techniques discussed in this web site offer great protection to small businesses against unnecessary IRS invasiveness. For more details on this, see my books The IRS Problem Solver and How to Win Your Tax Audit.

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  When to use independent contractors

Independent Contractors (IC) can be a great resource for small businesses needing help on a part-time, sporadic, or inconsistent basis, or for the performance of services that are outside the immediate scope of the business’s expertise. Independent contractors can provide that help. However, the IRS has cracked down tremendously on the use of ICs. The IRS likes to claim that the workers are really employees masquerading as ICs. As such, the agency often reclassifies the workers as employees, assessing delinquent withholding taxes, employment taxes and penalties against the company.

But there are twenty guidelines published by the IRS to determine whether a worker is an employee or an IC. Knowing these guidelines can prevent the IRS from converting your ICs into employees.

The overarching factor in determining whether a worker is an employee or an IC is that of “control.” Who controls the worker, the workplace, and the manner in which the work is performed? When these elements are controlled by the company, the worker is an employee. When they are controlled by the worker, the worker is an IC. Other factors that bear on the issue include:

Three of the most critical guidelines are as follows:

No. 1 – An IC may not work exclusively for you full time.
For example, an artist may work for an advertising agency upon demand. If at any time that artist begins to work exclusively for the agency on a full time basis, that artist must be made an employee. If the artist works exclusively for the agency even on a part-time basis over an extended period of time, the artist is probably an employee. But if the artist offers his services to other businesses and performs services to the public free of intervention from any company, the artist if probably and IC.


No. 2 – An IC must be allowed to work on his or her own clock.
If you require the worker to work specific hours at your place of employment, the worker is probably your employee, not an IC. IC’s must be able to control the workplace and how the work is done. If the IC works at home or on the customer’s premises but sets his own hours and dictates the manner of doing the work, he’s probably not an employee. This is the crux of the “control” issue discussed above.

No. 3 – An IC must provide his own tools and equipment.
To be true Independent Contractors, ICs must provide their own tools and equipment of the trade. The plumber must use his own pipe wrench; the electrician must use his own wire stripper; and a mechanic must use his own spark plug wrench. ICs must also provide their own transportation and, when required by local law, their own license and insurance. If the worker is using the tools, equipment, vehicles, etc., and is under the license and insurance of the company for whom the work is performed, the worker is probably not an IC.
Other guidelines apply and one should not use ICs or classify someone as an IC if these guidelines cannot be met. The consequences of losing all the benefits of IC status are staggering. For all the rules on using Independent Contractors, including detailed suggestions for written contract language, see my book Dan Pilla’s Small Business Tax Guide.

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Turn your hobby into a business

You might be shocked to learn that 20% of all small business audits involve disallowing deductions because the IRS reclassifies the small business as a hobby under the so-called “hobby loss” rule. This rule is one of the most misunderstood tax rules by small businesses and tax professionals alike.

It is a common misconception that in order to avoid the “hobby loss” rule, a small business must show a profit in three of five years or it is not entitled to deduct its expenses. That rule simply does not exist. What the rule does say is that a legitimate business exists if there is a legitimate intent to make a profit, whether or not profits were earned.

For example, in the case of Amway distributors, the potential to make a profit is obviously real. Many people make big money in that business yet the IRS has made what amounts to a system wide determination that all Amway distributors are nothing more than hobbyists looking for a way to get out of paying taxes.

A good tip for anyone who intends to start a small business is to first write a business plan that lays out your plan of attack for success. It should include sales goals, projected expenses and projected revenues. If it looks like the business may operate for a period of time on a break-even basis or even at a loss, say so in your business plan. This will not only help you become successful in your business, but will help answer the question regarding profit motive if the IRS challenges your business.

When you know the “hobby loss” rules, you’ll never have to worry about the IRS reclassifying your business as a hobby then disallowing all your deductions. Even better, when you know these rules, you might to willing to trying converting your hobby into a legitimate business that you might grow into a steady and reliable income source.

Dan Pilla’s Small Business Tax Guide, shows you how to legally convert a hobby into a legitimate business and how to defend yourself against an IRS attack on your business.

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