How can network marketing/MLM business owners reduce the risk of an IRS audit?
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 of all, the chances of the IRS selecting your tax return for 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 your company for 10 years or more make it 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 greater the chances of getting audited at least once. And if irregularities are found, the audit ray can fall more than once! So… let’s 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 Darwin invented, but it applies here nonetheless. The IRS just 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 the tax laws. In times past, lawyers, car dealers, and funeral homes, for example, had a target on their backs.
3. DIFF 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 typically slow to file (missing filing deadlines) or quick to file amended returns (seeking larger refunds), you may be at higher risk of a tax audit. Accidental noncompliance, 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 prevent blinding DIF scores or random selection, one thing you can and should do is keep good records. Always carry an appointment book or stopwatch with you to record car mileage, trips, and meal/entertainment logs. You must also keep special records for the equipment you use for both business and personal purposes. Computers, cell phones, and vehicles used for both business and personal use are prime 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 on taxes than you’ll spend on 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 doesn’t care if you pay the right amount of tax or if you overpay. 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 “Audit Proof” is to properly document your expenses and make sure you get sound advice from your tax accountant.
