This tax season, lots of people are getting audited in our industry. This month in particular causes my inbox to be flooded with a variety of tax-season revelations. The two most popular revelations this year are: “I’m not really an independent contractor?!” and “The IRS is auditing my business because I misclassified staff on accident!”
A third contender is rising up the list this week and that is, “My salon was chosen for random auditing!”
Cash based businesses, like salons, are often targeted for random audits. Sometimes it is through absolutely no fault of your own, but sometimes your return flags your business. The audit rate is roughly 1 in 100, but we’re in a unique position that puts us at special risk. Salon owners and independent professionals that make $200,000 or higher have an audit rate of 3.26% (1/30). If you make more than $1 million, in addition to being the luckiest bastard alive, you have a 1 in 9 chance of being audited.
Here are some tips for avoiding an audit:
1.) Watch your deductions.
Your deductions should be realistic and typical. A typical deduction is a recurring business expense, like your online booking service or your salon’s rent. Daily commuting to and from your work is not a legitimate deduction. The general rule is that anything you have to spend money on to make money on is deductible. Don’t claim things that are questionable. For our industry, a trip to a trade show is understandable. An extravagant European cruise is not. Big deductions for meals, travel, and entertainment are inviting audit. To qualify for meal or entertainment deductions, you must keep detailed records that document for each expense the amount, the place, the people attending, the business purpose and the nature of the meeting. Without that documentation, you get no deduction.
2.) Be able to verify your deductions.
If you can’t verify your deduction, don’t claim it. Get yourself a receipt scanner and an expandable file. Scan your receipts and save them on Dropbox. Back them up on a portable harddrive or thumbdrive. Keep the originals in the expandable file. Both the harddrive and the expandable file should be kept in a fire-safe box. (I’m a big fan of fire-safe boxes, if you couldn’t tell.) This way, if you’re ever audited, you can correspond your deduction with the original receipt. Some places give really crappy receipts, so if you need to notate what the expenses were, do so on the back of the slip. Simple actually makes this really easy by allowing you to attach photos and notes to your transactions, as well as hashtags, categories, and GPS tagging. In an audit, that type of documentation is your best friend.
3.) File online.
Sometimes, mistakes happen when IRS representatives manually enter your handwritten return information into the system. Numbers get omitted or added. This mistake that is entirely out of your control can cause you to be audited. Eliminate the middle man entirely and e-file. According to the IRS, the error rate for a paper return is 21%. The error rate for electronically filed returns is 0.5%.
4.) Eliminate the “cash” from “cash business.”
The IRS knows that those who receive primarily cash are less likely to accurately report all of their taxable income. So, eliminate cash from your business. This is a personal decision I made when I ran my business. I don’t like cash. I don’t like that it’s impossible to track, I hated counting it every night, I hated filling out deposit slips every night, and I hated depositing it every evening. (When I’m done working and cleaning up, I just want to walk out of the building.) In addition, I often worked alone in the building and both my husband and the doctor I worked with worried about me getting robbed. I made the decision to quit accepting cash payment and cash gratuity entirely. I implemented a new policy and only took traceable forms of payment. This included checks, gift certificates through SpaWeek, credit cards, and instant transfers from Paypal. Not only did this policy make me less likely to be audited (and robbed), it simplified my accounting, saved me daily trips to the bank, and gave me peace of mind. I got an account with Simple (an entirely online bank without branches that doesn’t take cash deposits unless they’re turned into money orders and submitted as checks) and never exchanged physical currency again. Checks were instantly photo deposited and destroyed once they cleared. None of my clients paid with cash anyways and this policy didn’t generate any complaints at all. I think as a modern society, we’re all moving towards digital currency. For me, this was one of the best decisions I could have made for myself and my business, but it does have a downside. Payment settlement entities have been required since 2012 to report all credit card transactions to the IRS on Form 1099-K. This includes Visa, MasterCard, and American Express, as well as online merchant processors. The IRS compares your credit card and cash receipts with your industry average. The IRS may send you a letter asking you to re-examine your books to make sure you didn’t omit any cash transactions if they feel your non-cash transactions make up too large a percentage of your annual revenue. To protect yourself from this, make sure your refusal to accept cash is clearly stated on your website, your brochures, and posted in your business. Keep your appointment records and your daily sales records. It shouldn’t be difficult at all to compare each appointment from the book with the corresponding payment record, especially now that many merchant service companies provide and store digital signatures and digital receipts.
5.) Hire a bookkeeper and accountant.
Managing your own business finances puts you at risk. Turn that responsibility over to a professional. It’s a small annual investment that can pay off big. If you’re going to be itemizing (which you most likely will be), do yourself a big favor and hire a professional to keep you organized. Focus on making the money. Let someone else handle the paperwork.
6.) Cross your T’s and dot your I’s.
Make sure your social security number is correct. Don’t round your numbers. Make sure your math is perfect. Triple-check every figure. Leave nothing blank. For the love of God, this is 2014. If you aren’t using software to file, get out of the stone age and start doing so now.
7.) Incorporate if you’re self-employed.
Small businesses are a favorite target of the IRS…and for good reason. Self-employed people are most likely to underreport income and overstate deductions. They make no distinction between whether you’re high-grossing or not. If you are self-employed (booth renters, I’m looking at you), consider incorporating or forming a limited liability company (LLC). Corporations and LLCs are audited less frequently than other small businesses. Incorporating or forming an LLC also allows for more deductions.
8.) Watch your charitable deductions.
The IRS knows what the average charitable donation is at every income level. If your salon holds a charity event where services are rendered in exchange for donations to a particular charity, be sure to document everything. When I worked in management, we held cut-a-thons for charity twice a year. Each client filled out a form with their contact information, the services rendered, and the donation made. They received a receipt from us so they could also claim that charitable donation themselves. Always consult with a tax professional when claiming those charitable deductions to ensure that you have all the documentation necessary to justify that deduction.
9.) Have your staff accurately classified.
This is so important, I should have made it number one. By now, anyone who has read this blog should understand that the Independent Contractor classification absolutely DOES NOT apply to our business except in very specific, limited instances. The best way to put yourself at risk for an audit is to have employees classified as Independent Contractors. All it takes is for one of them to get informed and file an SS-8 against you. It’s that easy. Not only will your business be audited, but you’ll be put smack in the middle of a labor dispute with your Attorney General’s office (or the Department of Labor, depending on your state). If you’re using more Independent Contractors than employees, the IRS sees that as a huge red flag since many owners do this to avoid paying employment taxes on their staff. When it comes to payroll tax debt, the IRS has unyielding power and authority to collect. (They can lock your doors and shut you down without a court order.) It’s common. It’s fugly. And you don’t want any part of that.
10.) Expect it.
That’s right. Expect to be audited and be prepared for it before it happens. That way, if/when it does happen, you’ll be ready for it. Keep yourself organized. Keep yourself honest. Remember that even the most minor illegal, fraudulent activities are indefensible in the eyes of the IRS. Run everything by your accountant/bookkeeper. If what you’re doing seems wrong, don’t do it because it probably is wrong. In this situation, your best defense is excessive preparation and organization.