Small Business Accounting Methods

Research Summary

Its safe to say that small business owners want to avoid a tax audit at all cost. There are ways to draw attention to your business, and there are also ways to avoid trouble with the IRS. When dealing with the IRS, it is important to use the correct accounting method, have accurate business mileage information, report exact business expenses, and provide proof of charitable donations.

Accounting methods for small businesses are not treated the same way as large businesses. Large business use the cash method of accounting, but it is better for small business use the hybrid method. When using the hybrid method, Sales and COGS are recorded by the accrual method and operating expenses are reported by the cash method. For this reason, inventories will be understated at any given time, because they are not actually paid for when they are received. If the IRS notices a problem with how the business is accounting for inventory, it will open their eyes for further exploration.

Another important tax factor is the way business report automobile mileage deductions. There are two different ways to deduct mileage. A business can use the standard deduction method or the actual-cost method. Either way mileage is recorded, the important thing is having exact records to back what is stated on the tax return form.

It is common for the everyday businessman to exaggerate business expenses. People have a tendency to overstate expenses, or report personal expenses as business expenses. If a red flag is thrown by the IRS, it is vital to be able to provide the needed receipts, as well as remember who you were with at the time of the event recorded. Although an oral explanation can be used to argue the expense, it is better to have a receipt as proof to remove all doubt.

An additional way to draw attention from the IRS, is by having a disproportional charitable donation. If the IRS looks and sees that a donation makes up a substantial portion of income, they will immediately be suspicious. When they question the business about it, it is crucial to be able to supply adequate documentation so your deduction is not taken away. A tax audit is not something that a small business wants to have to deal with, so by following a couple of rules, they can possibly avoid one.

ARTICLE

MINDING YOUR BUSINESS: Five ways small firms can run afoul of the IRS

IRIS TAYLOR

TIMES-DISPATCH COLUMNIST Feb 19, 2007

Is your small business ready for a tax audit?

You might as well get ready for one if you ignore the following five red flags, said Paul V. Thompson, principal at Premier Tax & Accounting LLC. in Alexandria, and Donna LeValley, a tax attorney and J.K. Lasser spokeswoman:

Using the wrong accounting method. Most small businesses use the cash method, said Thompson. They report income when it is collected and deduct expenses when they pay them. But, if you're a small business that has inventory, you should be using the hybrid accounting method, he said.

Using the hybrid method, inventory is deducted in the year that it is sold, not when it is purchased. "If I bought $5,000 of inventory on Dec. 28 and didn't sell it until in the next year, I can't deduct it in the current year because I haven't sold it yet," he said.

How can you get into trouble with the IRS? If you report that you're in the retail business selling widgets, "they're going to be looking for your inventory on the form," said Thompson. "If it's not there, they'll probably take a lot closer look at your return." First, you may receive a letter asking how you're accounting for inventory.

Then, "if you get audited, they are going to make the correction for you