Keeping the auditor from the door

By Stan Luxenberg

Only a fraction of all businesses are audited each year. Some day, the tax man may come calling. But why call attention to yourself? There are ways to lower the odds that your business will be on the auditor's itinerary.

While IRS auditors do not reveal the exact guidelines they use in selecting returns, accountants have deduced certain general tendencies. Agents appear to focus on returns that seem most likely to produce additional taxes. More complicated returns are more likely to attract attention.

Bigger companies are more likely to be audited. In 1988, only 0.47 percent of corporations with assets of less than $50,000 were audited. The IRS audited 16.14 percent of corporations with assets of $10 million to $50 million. Large, miscellaneous deductions and late payments of payroll taxes attract notice. The government also hates sloppy and incomplete records. "If you have poor records they may audit you every year," cautions Ronald H. Drucker, a partner of the accounting firm Laventhol & Horwath.

Family businesses are most likely to raise a red flag for excessive compensation or for using business funds to pay personal expenses. Owners of companies that are traditionally structured and pay dividends that face double taxation may be tempted to mastermind maneuvers that will lower taxes. One tactic is to allow cash to accumulate in a company. When a soft drink bottler paid limited dividends, the IRS frowned. It taxed the accumulated money, arguing that the dividends had simply been held in the company.

Paying family members lavish salaries can lower taxes, but even that has its pitfalls. Because salaries are deducted from corporate earnings, huge salaries can reduce corporate taxes. Instead of declaring dividends, some companies try to declare big end-of-the-year bonuses.

But excessive or erratic salaries can attract the interest of IRS auditors. For closely held businesses there are no clear guidelines for what may constitute reasonable salaries. Auditors attempt to determine typical salaries in the industry, but in the end they must make a subjective judgment based on the income of the business. "If Lee Iacocca makes $1 million, that may be a reasonable salary," says Mike Nelson, a senior tax manager at McGladrey & Pullen, a Minneapolis accounting firm. "If the mom and pop owners of a corner grocery pay themselves $1 million, that might be considered excessive."

By becoming a Subchapter S corporation, a business sidesteps some tax problems that might attract auditors. S corporations pay all their income to owners and there is no double taxation for dividends. However, salaries must still be reasonable. Older family members in higher tax brackets may be tempted to pay excessive salaries to children. Some families try to reduce their total personal income tax by shifting more income to family members in lower brackets.

Some companies have paid salaries to relatives who do not work in the business at all. IRS auditors may demand documentation that members on the payroll are actually doing jobs that would command the salaries listed.

Loans made by shareholders to the company or loans from the company to the owners can attract the attention of auditors. The government may be concerned that a corporation is making loans instead of declaring taxable dividends. Loans from a family member to a company must be for solid business reasons and not simply to avoid taxes.

Some family businesses have loaned money to children to start a new business. The IRS monitors such transactions to make certain that the loan is repaid—otherwise, it may consider the loan a gift or dividend that is subject to taxes.

A family real estate business ran afoul of the IRS when one member declared he had made a personal loan to a money-losing business and took a deduction. Because the investor had been involved in many partnerships and businesses, the IRS concluded that the loan had been a transfer of funds from a partnership to the business. In that case no personal deduction was initially permitted. The family spent $25,000 and two years to persuade the IRS the loan was valid.

While the taxpayer was vindicated, his accountant did have some sympathy for the government's position. The whole audit could have been avoided, he concluded, if the real estate company had provided more complete documentation with the initial returns.

In other cases, if a deduction is disallowed, owners may believe the company can simply pay the tax plus any penalties. In the meantime, the company has had use of the money.

However, accountants urge caution. Major irregularities can result in criminal penalties. Even more routine penalties can be more expensive than business owners mightexpect, says Milton Stern, a partner in Hannoch Weisman, a law firm in Roseland, New Jersey.

There is a three-year statute of limitations on audits. However, when the IRS begins auditing one year's returns, the agent may take a look at those from earlier years on which the statute is about to run out. The government may insist on getting an extension on the statute of limitations. "You can wind up paying taxes and penalties on returns of three or four years," notes Stern.

Stan Luxenberg, who writes an investment column for the Sunday New York Times, reports on business for many national magazines.