Avoid These Seven Common Business Tax Mistakes
What's the most unfortunate part of making a mistake in filing your business taxes? Yes, it's an audit notice. Being audited is probably one of the few business events that makes even missing a week or two of work for jury duty look attractive.
Though there are many more possible mistakes you can make, these six tax errors are the ones you'll want to avoid most.
1. Not knowing the serious difference between tax avoidance and tax evasion
"Tax avoidance" means taking legal steps to reduce your tax bite. A good accountant who's up to speed on current tax code can help your business take every possible deduction and reduce its taxes.
Tax evasion is an illegal way to pay lower taxes or no taxes at all, by withholding or providing false information to the IRS. Depending on the evidence, the IRS may consider this a civil or criminal act, per Title 26 of the Internal Revenue Code. As you may imagine, the consequences of breaking a federal tax law can be steep, with the maximum penalties being ten years in jail and $250,000 in fines. (In 2022, a total of 401 individuals went to jail for tax evasion. That's a 22.4 percent decrease since 2018, but still a problem.) You'll also need to pay the actual tax bill, plus interest and legal fees.
2. Over-reporting business expenses to increase deductions
Some entrepreneurs and/or their accountants may make some poor judgment calls on tax deductions — that's understandable. But others abuse the process by deducting dinners, lodging, gasoline, or other expenses that have nothing to do with their business activities. For example, claiming you took 55 clients to dinner last year in support of your at-home upholstery business will likely raise a flag.
3. Under-reporting business income
Technology advances such as PayPal and Venmo provide an electronic audit trail of transactions, making it almost impossible for a business to hide its income. However, some crafty business owners may still solicit cash payments from their customers. They may sweeten this illegal practice for their customers by offering discounts, since the business is also failing to pay sales taxes. Sure, accounting mistakes happen. But if the IRS discovers a pattern of "errors?" Well, they're much less likely to see them as mistakes anymore.
The huge reach of Internet commerce has also created opportunities for businesses selling online to avoid paying sales taxes. Current laws require businesses in 43 states, including parts of Alaska, and the District of Columbia to collect and file sales taxes, even if the customer is not in the state(s) where the business has a presence (also called a "nexus"). If you're doing business online, consult with your accountant to determine the extent of your sales-tax collection responsibilities.
4. Skipping out on employer taxes
Do you pay any employees under the table or off the books? Despite the IRS's best efforts, evading employer taxes is a rampant practice. In fact, a recent report found that in the construction alone, employers are paying between 1.1 million to 2.1 million workers off the books.
Both employer and employee may lose a lot by averting taxes: Businesses risk getting caught, paying penalties and back taxes, and being brought up on fraud charges. An illegally paid employee loses out on contributing to their Social Security benefits, among other essential employee protections like disability insurance.
5. Mixing business and personal dollars
Mixing business and personal expenses is a common abuse of tax laws, especially with sole proprietors who don't understand the importance of maintaining separate personal and business bank accounts. By failing to create this separation, you may make honest mistakes that turn into costly problems. If, for example, you use the same credit card for business expenses, vacations, and everyday shopping, how will you really know what's what come tax time? Instead, save yourself the stress and separate all expenses.
6. Indulging in "lifestyle creep"
Lifestyle creep is the fiscally irresponsible practice of inflating non-essential expenses, usually to convey a false idea of wealth and a prosperous business at the cost of your business's health and well-being. Example: Having a weak profit and loss statement, while driving a new Tesla, collecting rare post-Modern art, and renting a $12,000-a-month penthouse apartment. Though this is a poor practice for any entrepreneur, it's particularly unethical for a business owner who's working with others' equity and supports their employees' livelihoods.
7. Misusing and/or abusing the home-office deduction
People working from home in a designated office space often over-inflate their home-office allowance. For example, how can you truly figure out how much of your heating oil and water your office space uses? When you make lunch, can you write off the kitchen utensils and appliances? Some tax advisors suggest not even taking this deduction, since it practically invites IRS scrutiny.
Avoid problems: Rely on the experts
Tax professionals are trained to recognize these and many other risky areas of tax law. Hiring one helps you avoid costly and time-consuming mistakes. But if you have the misfortune of being audited, hiring a tax professional who advocates on your behalf can resolve the problem satisfactorily and at a lower cost.
Did you know?
The Internal Revenue Service spent $5.4 billion, or 38 percent, of its 2022 funding on enforcement expenses — its largest budget allocation.
Source: 2024 Wells Fargo Impact of Women-Owned Business Report
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FAQs
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If you decide to use a tax professional, consider choosing a Certified Accounting Professional (CPA). In many states, these specialists are required to accompany you during an audit to represent you. They also sign with their CPA designation on your tax returns which could help avoid audits.