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.


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."


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."


Take advantage of special employment credits

The tax code is full of business credits for hiring people who have trouble getting work: welfare recipients, ex-felons, residents of empowerment zones, etc. If you have any such employees on your payroll, you may be eligible for one of the credits. The two biggest breaks are the work opportunity credit and the welfare-to-work credit.

You can't take both for the same employee, so look to the welfare-to-work credit first: It will lower your taxes by a maximum of $8,500 per employee over two years versus $2,400 for the work opportunity credit. That credit, however, covers a broader array of workers--including felons, youths, and others with high unemployment rates. What's more, as part of the Hurricane Katrina disaster relief program, you can also use it for hiring workers displaced by the hurricane. One caveat: Many of these credits expired at the end of 2005, so while you'll get to claim the credits on your taxes this year, unless Congress acts soon, and retroactively, they may not be available again. "They have been renewed year to year, but Congress is running late," says CCH's Gada. That uncertainty could make future planning tricky.

Employee Perks

Write off the fringe benefits

Employers provided an average of $18,358 in benefits per employee in 2003--largely for health, retirement, and paid time off--according to a recent survey by the U.S. Chamber of Commerce. That's an enormous expense, but the upside (at least at tax time) is that those costs will reduce your tax bill substantially. In addition to the usual write-offs for health insurance premiums, employer retirement contributions, and vacation pay, there are some often-overlooked benefits that can make your employees happy and lower your taxes, too. Lunches provided in the office to employees, for example, are 100 percent deductible, as are holiday parties and company picnics. But here's one place where there's an important difference between a C corp and an S corp. A corporation can write off those fringe benefits regardless of who gets them and the recipient doesn't have to pay taxes on them. But S corp owners or employees who own 2 percent or more of the enterprise will find most of their fringe benefits treated like taxable income.


Use the research tax credit

20% of R&D expenses can be written off. "The credit has saved us more than $50,000," says one entrepreneur.

The research tax credit isn't new (in fact, it dates back to the 1981 tax reform), but it can save you a bundle if you've spent heavily developing new technology or improving your product. In tax year 2001 (the most recent period for which data is available), 10,388 corporations--excluding S corps and other flow-through entities--claimed $6.4 billion in research tax credits. Calculating the tax break (reported on Form 6765) is complex, but you basically get a credit of 20 percent of the cost of your R&D, including the costs of labor. Daniel Thralow, chief executive of Thralow Inc., based in Proctor, Minnesota, rang up $20 million in revenue in 2005 from a slew of specialty online shops including and; he used the research credit to help offset the costs of developing customized software to run the company's various sites from the same warehouse and distribution center. "My accountant came to me and said, 'You are working on this database software and we think it falls into this tax-credit category, and you should hire someone to research it," Thralow says. So he hired a tax attorney, who wrote a formal memorandum on why Thralow would qualify--an important step, just in case the business is ever audited. "The cost of the attorneys was around $5,000," Thralow says. "But the credit has saved us more than $50,000 so far."

Capital Spending

Max out your expensing

Section 179 of the tax code, which allows businesses to expense rather than depreciate capital expenditures, is one of the biggest breaks available to businesses. For 2005, companies can expense up to $105,000, compared with $102,000 last year. By expensing capital outlays, you get the full tax benefit of that purchase today, rather than writing it off over many years. If you spent heavily in 2005 on new computers, for example, or on furniture for a new office, this could be a substantial sum. After all, if the business is set up as an S corp and you're in the 33 percent tax bracket, a $105,000 write-off could cut your tax bill by nearly $35,000.

The plane is a big expense, but I need one with how much I travel. " --Zak Brown, CEO, Just Marketing International

Zak Brown, a former racecar driver and now chief executive of Just Marketing International, an Indianapolis-based motor-sports marketing firm with $30 million in revenue, says he'll be Section 179-ing the purchase of a corporate jet. "The plane is a big expense, but I need one with how much I travel," Brown says. Some accountants consider that an aggressive move, as planes and cars tend to be looked at closely by the IRS. But it's perfectly legit as long as it's a true business expense.

State Returns

Don't forget local tax issues

You may not think of yourself as owing taxes outside your home state. But state authorities may have different ideas, depending on where your employees and facilities are located, where you conduct sales, and a variety of other factors. It's a thorny issue that you'll need a good accountant to help navigate.

Further complicating matters, states have increasingly decoupled from the federal tax system on key tax changes. Some states do not recognize Section 179 and QPAI deductions, for example. Say you've made some significant equipment purchases and take Section 179 expensing on your federal return. You may not be able to do that on your state return--or you may be limited in the amount you can expense. In other words, figuring out a tax strategy for your federal return may not do you much good at the state level. There is little you can do here except to consult with your accountant, keep close tabs on the rules of the states that you file in--and be prepared to crunch at least some of your numbers in multiple ways.

Salaries Vs. Dividends

Pay yourself appropriately

This is a big and often confusing issue. Do it right, and you can get big savings; do it wrong, and IRS scrutiny will almost certainly follow. If you've set up your business as a C corporation, your compensation qualifies as a deduction at the corporate level and is taxed at the individual level at marginal rates. If the payment is made as a dividend, it does not qualify for the deduction at the corporate level, but the recipient will be taxed at the low dividend rate of 15 percent. Which is the better strategy? That depends on whether you're trying to reduce tax at the corporate level (by paying out higher salaries and taking larger deductions) or at the owner level (by using dividends). You can't go overboard on salaries here to get a massive deduction, though. Tax rules require salaries to be "reasonable" (there is no set definition, but authorities look for salaries to be generally in line with salaries at similar companies); if they're not, the IRS may redesignate some portion of them as dividends.

The situation is reversed for S corps and other pass-through entities because the business itself owes no tax on the income; the owners do. If you're the owner, you'll have to pay self-employment tax on your compensation (12.4 percent for Social Security up to the cap, plus 2.9 percent for Medicare) but not on flow-through income from the business. Obviously, the less money you take as compensation, the lower your tax bill will be. But you can't go overboard here either. The same rules about reasonable compensation apply; in other words, you can't pay yourself nothing and expect to get a tax break as a result. In fact, says Skoda Minotti's Steven Hartstein, the IRS has begun scrutinizing certain companies that have done precisely that. "This is the hottest issue," he says. "Some advisers told their clients that they didn't need to take any salary whatsoever, and those people are getting killed in audits."

Cash Vs. Accrual

Change the way you count your cash

The way you account for your cash has a huge impact on your bottom line and your tax bill. Broadly speaking, there are two ways of accounting for tax purposes--the cash method (meaning you report income in the tax year you receive it and deduct expenses in the tax year you pay them) and the accrual method (in which you report income when you earn it and deduct expenses when you incur them, regardless of when the payments are made or received). Large businesses and those that keep inventory on hand are required to use the accrual method, but smaller companies get to choose. Which one's better? It depends on your cash flow and overall level of income and expenses. One advantage of the accrual method is that it tends to smooth out net income, eliminating peaks that may be taxed at a higher marginal tax rate. The cash method, however, offers more flexibility in pushing income to a later year or accelerating deductions into the current one.

But beyond the broad decision between accrual and cash accounting methods, there are numerous other accounting choices--on items such as advance payments and prepaid expenses, for example, or depreciation--each of which has its own impact on the bottom line and your tax bill. You'll need to talk with your accountant to figure out which ones are best for you. Many changes can simply be reported to the IRS, though certain moves require advance approval. "You shouldn't shy away from changing to a beneficial accounting method just because it is something that the IRS will be aware of," says PricewaterhouseCoopers' Carolyn Canova.

Real Estate

A new way to depreciate

Accountants are talking a lot about something called "cost segregation" for real estate assets. It could save you a bundle if you operate a major manufacturing facility. With cost segregation, instead of simply depreciating your holdings in one big lump sum over 39 years (as required for commercial real estate), you divide the property into pieces, some of which (specialized plumbing or electrical systems, for example) can be depreciated much more rapidly. The result is a lower tax bill and improved cash flow today. Real estate investors have been doing this for years, but tax accountants have only recently begun applying the strategy to a broader range of clients. You'll likely need to do a cost-segregation study before you proceed, which can cost thousands of dollars. David Grant, director of the real estate group at Mintz Rosenfeld & Co., an accounting firm in Fairfield, New Jersey, says that 20 percent to 40 percent of the cost of a property typically can be reclassified to a shorter depreciation timetable. "A warehouse will be closer to 20 percent and a nursing home or manufacturing facility will be closer to 40 percent," he says. Margaret Amsden, an accountant at Clayton & McKervey in Southfield, Michigan, adds that if you've purchased a building with extensive electrical, mechanical, or plumbing upgrades, carving out those pieces for shorter depreciation will likely give you bigger tax savings.

A couple of caveats: If the real estate is held in an entity separate from the operating company of the business, you may run up against the passive-activity loss rules, which limit losses permitted for tax purposes and could reduce or wipe out the benefit. What's more, the strategy is best suited for properties valued at $1 million or more, given the up-front costs involved.