5 Tips for Avoiding Tax Audit Triggers

Paying income taxes is painful enough without the specter of penalties and interest. But that’s just what you’ll incur if an IRS audit reveals you broke the rules. Here are five tips for avoiding those audit triggers that can tax your construction company in more ways than one:

1. Report all business income. You must pay taxes on income received for all work, including side jobs and work paid for in cash. This includes work done in exchange for credit on a bill and for goods or services in a barter exchange. Even if you don’t receive a Form 1099 or a W-2, you must report all income.
2. Watch business deductions. To be deductible, business expenses must be “ordinary” and “necessary.” Both conditions must be met. Ordinary and necessary expenses that may be deducted in the year incurred include utilities, car and truck expenses, employee salaries, trade association dues, supplies, continuing education, and small tools expected to last one year or less.

You can’t deduct personal expenses, such as clothing that can be worn off the job site, fines and penalties, and the nonbusiness use of vehicles or computers. Other expenses, including certain meal and entertainment expenses, may be at least partially deductible.

3. Apportion expenses consistently. Construction projects often straddle two or more tax years. When they do, you need to determine whether you should recognize income and expenses proportionately or wait until completion. And the answer depends on whether you operate on the cash or accrual method of accounting, or a long-term contract method.

With any method, you must be consistent and there must be a matching of income and expenses. Don’t deduct certain expenses now if you plan to wait until next year to account for revenues.

4. Follow standards of reasonable compensation. If you operate your construction business as a corporation, make sure you pay any shareholders who work for the company within the standards of “reasonable compensation.” What’s considered reasonable is subjective, but the basic rule is that shareholders should pay themselves what they would pay others to do their jobs.

In an S corporation, the IRS may reclassify excessive distributions as wages, making the shareholders liable for payroll taxes on the total amount. In a C corporation, the IRS may consider a high salary as dividend income and deny deductions for any associated compensation expenses.

5. Don’t bill personal expenses to the company. The IRS is on the lookout for contractors who improperly bill their companies for the cost of making improvements to their personal residences or other real estate to reduce their tax liability. To detect improperly billed personal expenses, auditors pay close attention to contracts, billings, invoices, completion notices and other related paperwork.

Following these five tips will go a long way toward reducing your chances of being audited, but there are no guarantees. If you’re selected for an audit, contact your CPA immediately. He or she can help make the IRS encounter less painful by handling most of the interaction, determining what information is appropriate to provide and making sure the process is as efficient as possible.

Contact Tim Ayler at Tayler@greenwaltcpas.com or Brandon Cook at Bcook@greenwaltcpas.com if you have any questions, or give us a call at (317) 241-2999.