Inc.'s Annual Spectaxular
After years of decline, audits of businesses are on the rise. But that's no reason to pay more than your fair share. From new deductions for manufacturers to how to pay yourself, here are 10 ways to cut your tax bill--without raising the suspicions of the IRS.
At the IRS, entrepreneurs have become a big sweet spot. While large corporations often have teams of experts dedicated to keeping the tax collectors at bay, small companies are like low-hanging fruit--and that's especially the case today. The numbers tell the story. IRS audits of businesses had been trending downward since the late 1990s. But in fiscal 2005 (ended September 30), the number of IRS audits of small corporations (defined as those with assets of less than $10 million) jumped 145 percent, to 17,867--the highest number in five years. (The number of audits of large corporations increased 14 percent last year, to 10,878.) The enforcement revenue flowing to the IRS from businesses and individuals, meanwhile, soared to a new high of $47.3 billion last year. With an even bigger budget for enforcement in fiscal 2006 and IRS Commissioner Mark Everson promising to narrow the nearly $300 billion tax gap (the difference between what taxpayers, both businesses and individuals, are supposed to pay and what the government actually collects), business owners can expect more to come. "The machine moves slowly, but the IRS has more funds and is increasing its enforcement activity," says Paul Gada, a business tax analyst with tax publisher CCH in Riverwoods, Illinois. Entrepreneurs are vulnerable. For one thing, they don't always get the same level of advice as large companies, often because they can't afford it or don't think they need it. Growing companies also face rapidly changing financial situations, which tend to raise eyebrows at the IRS.
If there's a bright spot in this picture, it's that most of these audits are not the nerve-racking face-to-face encounters of years past. Instead, they're so-called correspondence audits, in which the agency sends a letter questioning your tax return and requesting more funds. There may be simple mistakes in document-matching or questions about missing documentation; in many cases, these IRS letters can be handled by simply sending an explanation and additional backup information in the mail.
If you're honest on your taxes and keep good records, rising audit numbers aren't necessarily bad news. Still, no one wants to be audited, and there's no reason to pay more than your fair share. With tax time here (the deadline for most C corporations and S corporations is March 15; partnerships, LLCs, and sole proprietors usually get another month) we've compiled 10 solid strategies that can help slash your bill. Some involve taking advantage of new or little-known tax breaks. Others are tried-and-true tactics you may not have considered recently. But all of them can succeed--without raising the suspicions of the newly vigilant IRS.
Deductions
A new break for manufacturers
The last major tax bill--the American Jobs Creation Act--was passed at the end of 2004, and several key provisions are taking effect for the first time this year. Perhaps the most important is a tax break designed to help domestic manufacturers compete against lower-cost overseas providers--the qualified production activities income deduction, or QPAI. It allows businesses to deduct 3 percent of the income from certain domestic manufacturing activities in 2005. The deduction will rise in subsequent years, hitting 9 percent in 2010 and beyond.
What constitutes domestic production? Because the tax break is so new, that's still being ironed out. All manufacturing activities qualify, but so do some services, such as architecture and engineering. It doesn't matter how your company is structured--the break is available to C corps, S corps, partnerships, limited liability corporations, etc.--but the deduction is capped at 50 percent of an employer's annual W-2 wages. Although the rules are complex and still in flux, the QPAI credit can amount to a large sum of money. And it's only going to become more valuable over time. At 3 percent, "it may not seem like a big deal this year," says Carolyn Canova, a tax partner with PricewaterhouseCoopers' private company services practice in New York City. "But as a company grows and the deduction does too, it could become much more significant."
Losses
Get the most out of your losses
Everyone has a tough year from time to time. If you do have losses, you might as well get all the tax benefit out of them that you can. The rules for taking business losses vary, depending on whether you're set up as a C corporation or as a flow-through entity such as an S corporation or partnership. C corps with net operating losses not only get out of paying income taxes now, but also are able to carry over any excess loss (known in tax jargon as a net operating loss carryforward, or NOL) to offset income for the next 20 years. That way, when you do post operating income, you can use as much of the loss carryforward as you need to offset it, then continue to roll over the rest. That's exactly what Métier, a software company in Washington, D.C., has done, effectively wiping out its tax bill to date. Founded in 1998, the company lost money for several years before turning its first profit in 2002. "We are still using those losses carried forward so we are not paying any taxes yet," says Sandra Richardson, Métier's chief operating officer. "Next year we are going to get a rude awakening because you can sure get used to not paying taxes."
Audits of small corporations rose 145% in 2005. "The IRS has more funds and is increasing its enforcement activities," says one expert.
For S corps, business losses will flow through to your personal tax return and you can use them to offset your wages or other personal income. In fact, because your personal marginal tax rate is likely to be higher than the corresponding corporate rate, the losses will usually be more valuable on your personal return--assuming that you have other income to offset (and enough money invested in the business to be allowed to do so). "If my only source of income is this new entity, it doesn't do me much good to have this loss on my personal return," explains Steven Hartstein, an accountant at Skoda, Minotti & Co., an accounting and consulting firm in Mayfield Village, Ohio, and an adjunct professor of corporate tax at Case Western Reserve University. "If I have a lot of income, I'd rather see the loss flow through to me, so I can use those losses against a higher marginal tax bracket."
