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 off, the odds of having the IRS select your tax return for an audit are very low. Roughly 1% of all taxpayers get audited in any one 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 big keys to success in network marketing is to “Never Quit”. The good news is that the vast majority of those who stay with their company for 10 years or longer hit the top position in the company’s compensation plan! The downside risk is that the longer you stay in business-any business-the greater the chances are that you’ll be audited at least once. And if any irregularities are found, audit lightning can strike more than once! So… let’s look at how tax returns are selected for an audit, and how can you reduce the risk of it happening to you.
The IRS selects taxpayers for an audit in several ways:
1. Random selection. Sounds like something Darwin made up, but nevertheless, it applies here. The IRS simply selects some businesses at random.
2. Targeted 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 noncompliance with the tax laws. In times past, lawyers, car dealers, and funeral homes, for example, have had a target on their back.
3. DIF scores. The IRS uses a method of computer scoring, called Discriminate Index Function ratios, to select taxpayers for an audit. This method identifies extraordinary tax deductions such as excess travel, entertainment, or vehicle expenses.
4. Document Compliance. If you’re typically slow to file (miss filing deadlines), or quick to file amended returns (looking for bigger refunds), you can put yourself at a higher risk of a tax audit. Haphazard non-compliance, or lack of attention to form details, can be like waiving a red flag and screaming “I’m over here! Audit me!”
While there’s not a lot you can do to avoid the glare of DIF scores or random selection, one thing you can and should do is keep good records. Always carry an appointment book or day-timer to record your auto mileage, travel, and meals / entertainment records. You should also keep special records for equipment that 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 usage requires detailed record-keeping.
If you’re 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. You’ll usually save far 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 might 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 even overpay your taxes. They DO care if you pay less than you owe, and also if you can’t substantiate deductions you’ve claimed on your return. The IRS doesn’t care if you overpay in one area–you will still get hit with interest and penalties if you underpay in another area.
In conclusion, the best way to “Audit Proof” yourself is to properly document your expenses and make sure you are getting good advice from your tax accountant.