Everyone has at least one pet peeve. The IRS has many. Here are some items that the tax agency may target on a manufacturer’s 2014 tax return — and ways to help safeguard against an IRS audit.
1. Owners compensation
A privately held C corporation may try to overpay its owners in lieu of paying dividends to avoid double taxation. Conversely, an S corporation that’s not subject to corporate-level taxes might try to underpay its owners to minimize payroll taxes and, instead, make higher distributions. The IRS is on the lookout for whichever ploy applies to your company and may compare your owners compensation to that of other manufacturers or distributors in your area.
How much should an owner get paid? There’s no right answer for every company. It depends on what unrelated third parties with the same responsibilities, schooling and experience receive for performing the same functions. Outside sources, such as headhunters and various compensation surveys, can be used to substantiate your owners compensation expenses.
2. Travel expenses
Private business owners sometimes push the envelope when it comes to combining business and personal travel expenses. But the IRS has strict rules on what qualifies as deductible business travel expenses.
For instance, suppose you attended the International Manufacturing Technology Show in Chicago last September. You visited the conference for two days but extended your stay an extra week to visit family in the Chicago area — and your wife and kids tagged along. How much of the trip can you deduct as a legitimate business expense?
In order to deduct travel expenses, the primary reason for the trip must be business, rather than personal pleasure. To validate the business purpose of a trip, the IRS usually considers whether your business travel days — including travel days to and from the destination, working days and standby days — exceed your personal travel days.
When this happens, you can usually deduct all your transportation costs, such as airfare, rental car fees and hotel costs, but not those incurred by the rest of your family. If the threshold isn’t met, you can’t deduct any travel costs, even if you conduct substantial business during your trip.
3. Meals and entertainment
Likewise, excessive meals and entertainment expenditures are likely to catch the IRS’s attention. You generally can deduct up to 50% of business-related meals and entertainment expenses incurred for the purpose of entertaining a client, customer or employee.
Maintaining detailed records is the key to protecting your meals and entertainment deductions. Your company’s expense reimbursement forms should require the following information:
• Amount of the expense,
• Time and place,
• Business purpose, and
• Name and business relationship of any person entertained.
Hold onto records supporting the items claimed until the statute of limitations runs out. (The statute of limitations usually runs out three years from the due date or the filing date, whichever is later.) However, the IRS can go back more than three years if it suspects a substantial omission of income or a tax fraud.
4. Net operating losses
When expenses exceed revenues, a business may incur a net operating loss (NOL). Businesses may elect to carry back (or forward) NOLs to offset income in other years. The IRS may ask your company to substantiate the loss, not only in the year it’s incurred, but also when a refund is claimed for an earlier (or later) year. So, proper record retention is essential with NOLs. IRS instructions recommend saving records until NOLs no longer have an effect, plus seven years.
Tax pros lower audit risks
A small percentage of tax returns are audited by the IRS. Sometimes a business is randomly selected. But in many cases, high-risk or excessive deductions trigger an audit. The IRS keeps “norms” on how much manufacturers under each industrial classification code typically deduct for each line item — but unfortunately it doesn’t publish industry norms to the general public.
IRS auditors often have a field day with do-it-yourself returns. An advisor who specializes in the manufacturing niche can evaluate your deductions line-by-line and help minimize your audit risks.