How to Stay Out of Tax Hell

Last Updated Feb 25, 2011 7:34 PM EST

By Kathryn Hawkins
Most small business owners are more concerned with running their businesses than running a fine-tooth comb over their books. But even simple mistakes in your accounting practices can lead to big trouble with the IRS, including audits, thousands of dollars in penalties, and potentially even jail time. Michael Rozbruch, CEO of Tax Resolution Services in Encino, Calif., shares tips on how your business can avoid trouble with the IRS.

Accounting is not your job... "When entrepreneurs start businesses, they may be great at building products, but they often fail in the back office," says Rozbruch. Many business owners try to track their expenses manually or through accounting software like QuickBooks. Bad idea, says Rozbruch: "If you don't have a bookkeeping background, you don't know what you're doing with QuickBooks."

Case in point: One of Rozbruch's clients ran an HVAC company with five employees, and hired his wife to do the bookkeeping. "She wasn't trained and didn't know how to do basic things like double-entry accounting," he says. "They thought they were making money because she wasn't putting entries in properly. She was showing a $300,000 gain for the year, when they'd actually lost $50,000." She also had difficulties paying payroll taxes on time. Her poor accounting practices cost the company big-time: Rozbruch said the IRS assessed them $175,000 in taxes, penalties, and interest. In the end, his firm was able to remove $50,000 and put them on an installment plan.

... But ignorance isn't bliss. Hiring someone to manage the financial side of the business is a good idea, but you still need to pay attention to what's going on. Rozbruch describes one client who owned a small business with revenues close to $2 million. "Every week, the accountant would present a cash flow projection to the owner that showed payroll taxes being paid," he says. "The owner simply took his word for it."

It wasn't until an IRS officer showed up at the company's door asking for $120,000 in back taxes and an additional $35,000 in penalties that the owner realized something was amiss. It turned out the accountant had embezzled all of the payroll taxes instead of paying them. Rozbruch negotiated an installment plan for his client, and today, the company is free and clear -- but the owner could have avoided a lot of drama by simply double-checking the accountant's facts in the first place.

Avoid audit red flags. "Never do a return by hand," cautions Rozbruch. Such tax returns are likely to contain mathematical errors, and will be inspected line-by-line. And if anything seems out of the ordinary, the company is likely to be audited. Be careful that you don't go overboard on business deductions, too: The IRS will analyze how well your net profits match up with your lifestyle. "One couple I represented lived in Palos Verdes, a very expensive suburb of Los Angeles," says Rozbruch. "The husband ran an import-export business with a gross income of $725,000, but they were only showing $140,000 in net profits." The couple's monthly living expenses included a $6,000 mortgage, $1,500 in car payments and two private school tuitions, so the disparity between their reported profits and living expenses set off alarm bells.

It turned out that the couple had overstated their business expenses by a long shot: "If the business spent $20,000 on advertising, their tax return showed $45,000," says Rozbruch. "They made up numbers." There were some valid deductions in their reported figures, but the couple received steep penalties for misrepresentations on their tax return.

If you are audited, show up well armed. Rozbruch says that most audits today are by mail -- a form called CP 2000 -- but if you're asked to come into an IRS office, he suggests you bring representation. "Going to the IRS office without representation from a certified tax resolution specialist is like going to court without a lawyer," says Rozbruch.

IRS officers will ask you a series of questions, which may be difficult to navigate without assistance. "They might ask you, 'Do you have cash at home or in a safe deposit box?'" says Rozbruch. "People get scared and answer 'No,' when the true answer is, 'Yes, but the taxes have been paid already.'" Most business owners feel intimidated, and will attempt to give the IRS officer the answer he wants, whether or not it's the right answer -- and that could cause big trouble down the line.

Always file your return, even if you can't pay the amount owed. "The biggest mistake I see with my clients is that when people don't have the money to pay what they owe, they simply don't file," says Rozbruch. That will result in a 25% 'failure to file' fee, plus an additional 5% 'late fee' each month -- potentially adding hundreds of thousands of dollars to your overall bill. "File your return on time and send a check for as much as you can afford, even if it's only $5," Rozbruch advises. "That will take the failure to file penalty off the table, and will move your account to the collections department, where you're much less likely to be audited."

No business owner enjoys the accounting side of the business, but it's much easier to maintain good practices now than to try to fight huge penalties from the IRS later. By setting up a reliable system, you can focus on running your business instead of worrying about Uncle Sam. "Get a bookkeeper, get an accountant, and review your financials on a quarterly basis," says Rozbruch. By being diligent with your practices, you'll avoid winding up in tax hell.

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