What kinds of items on your return trigger financial status audits? Since a financial probe isn't a specific type of audit but rather a component of a regular audit, you won't know in advance what the auditor decides merits questioning. Peter Pfister, a CPA with Curchin & Co. in Red Bank, New Jersey, suggests you are a target for economic reality testing "if you have reported negative or very low income and you have a large number of expenses or deductions. This is usually a red flag for the IRS to look at a business or personal return." Or, Pfister adds, you might be lucky enough to be in an industry that is being targeted by the IRS for audits because of a history of noncompliance. The restaurant and construction industries are current favorites of the IRS.
The lifestyle check comes into play during the office visit. "We're basically comparing what's on the return with what is visible to the eye," says Pyrek. "If someone has reported a very low income and also lists a boat as an expense, how is this guy living? There may be a logical explanation-or there may be some buried income."
In fact, while for many small-business owners there exists a gray area regarding what should be considered a business expense and what is a personal expense, careful documentation is not solely an exercise for personal returns. Heaney says that while it may be important to convey a prosperous image to your clients, this can all be done with borrowed money. The key is to be able to show the IRS that the money was borrowed and dispel any notions that you have buried income.
According to Pfister, the IRS targets certain sections of the business's return, such as benefits, travel and entertainment expenses, depreciation for office equipment and auto expenses, to see if income is buried there. These items are then compared against the IRS' national guidelines and levels; areas that exceed the established levels are zeroed in on for closer examination.