Network Marketing / Multi Level Marketing professionals often ask me “What are my chances of an IRS audit?” Many others ask, “If I overpay my income tax, will that make me audit proof?”
First, the chances of the IRS selecting your tax return for an audit are very low. Approximately 1% of all taxpayers are audited in a year. However, as a small business owner, you are much more likely to be audited than W-2 wage earners. In fact, sole proprietors (the legal entity structure for 80% of MLM businesses) are three times more likely to be audited than W-2 employees.
As you know, one of the great keys to success in network marketing is to “never give up.” The good news is that the vast majority of those who stay with their company for 10 years or more rise to the top position in the company’s compensation plan! The downside risk is that the longer you stay in business, in any business, the better chance you’ll get audited at least once. And if irregularities are found, the audit beam may fall more than once! So…let’s take a look at how tax returns are selected for an audit and how you can reduce the risk of it happening to you.
The IRS selects taxpayers for an audit in several ways:
1. Random selection. It sounds like something made up by Darwin, but it applies here nonetheless. The IRS simply selects a few businesses at random.
2. Directed selection. Certain types of businesses are more likely to be audited than others. The IRS will focus like a laser on certain businesses if experience has shown a high degree of non-compliance with tax laws. In times past, lawyers, car dealers, and funeral homes, for example, all had a target on their backs.
3. DIF scores. The IRS uses a computer scoring method, called discriminant index function coefficients, to select taxpayers for an audit. This method identifies extraordinary tax deductions, such as excess travel, entertainment, or vehicle expenses.
4. Compliance with documents. If you’re normally slow to file (missing filing deadlines) or quick to file amended returns (seeking larger refunds), you may be at greater risk of a tax audit. Haphazard non-compliance, or inattention to form details, can be like waving a red flag and yelling “I’m here! Audit me!”
While there isn’t much you can do to avoid the dazzle of DIF scores or random selection, one thing you can and should do is keep good records. Always carry an appointment book or timer with you to record car mileage, travel, and meal/entertainment logs. You must also keep special records for equipment you use for both business and personal purposes. Computers, cell phones, and vehicles used for both business and personal use are great examples; These are called “listed property” and the rules that dictate how much you can deduct for business use require detailed registration.
If you are serious about your network marketing business, you should maintain a separate checking account for the business. You should also hire a professional to prepare your tax return. Typically, you’ll save much more in taxes than you’ll spend in tax preparer fees. Tax professionals know the rules, prepare hundreds of returns each year, can lower your tax bill, and help you avoid mistakes that could otherwise lead to an IRS audit.
Will overpaying your income taxes make you audit proof? Repeat after me: they don’t care. The IRS does not care if you pay the correct amount of tax or overpay tax. They DO care if you pay less than you owe, and also if you can’t prove the deductions you’ve claimed on your return. The IRS doesn’t care if you overpay in one area; you will still receive interest and penalties if you underpay in another area.
In conclusion, the best way to “Proof of Audit” is to properly document your expenses and make sure you get good advice from your tax accountant.
