STILL AUDITED LESS: S CORPS, PARTNERSHIPS AND LLCs

Historically, the IRS has given less attention to businesses run as pass-through entities (S corporations, partnerships and multi-member LLCs) than those conducted as sole proprietorships and C corporations. 

Example: In 2001, a person with Schedule C income above $100,000 was almost three times more likely to be audited than an S corporation, and almost five times more likely than a partnership or multimember LLC. Similarly, a C corporation with more than $250,000 in assets faced substantially higher odds of being audited than a S corporation, partnership, or multimember LLCs (IRS Data Book, 2001). 

Despite the IRS new K-1 matching initiative, don't expect this trend to change. It doesn't appear the feds are gearing up to start auditing S corporations, partnerships and multmember LLCs with increased vigor. 

Reason: The pass-through entity tax rules are complicated, and IRS personnel are just not as up-to-speed as they should be. 

What to do: Consider setting up a pass-through entity to conduct your business activities. Doing so could actually lower your profile on the IRS' radar screen. Just make sure you properly report all K-1 items on your personal return and keep the rest of the return clean. 

Cut salary received from your S Corp. Use a salary cutting move to justify a reduction in your own salary. Reason: reducing you salary lowers the federal payroll tax hit which is 15.3% on the first $80,400 of 2001 compensation and 2.9% on any excess. Half the tax is paid by your company, and the other half is withheld from your paychecks. 

You still can withdraw as much cash as you wish from your S corporation by increasing dividend payouts to make up for your salary reduction. So the only real impact is a lower payroll tax bill. Is this legitimate? Yes. As an S corporation shareholder-employee, your salary shouldn't exceed what your company could pay someone else to do your job. If that amount is shrinking, this tax-saving move is beyond reproach. 

Source: Research Recommendations

HOW TO RECONSTRUCT YOUR RECORDS-LEGALLY

In this less-than-perfect world, chances are you won't be able to produce receipts, bills or other written documentation for all your tax return items being questioned in an IRS audit, especially when the audit comes several years after the tax year at issue. That's when you must reconstruct your records or amass the best proof you have.

It's perfectly legal to reconstruct your records in any way to provide adequate evidence that what you claimed on your return was correct. The law does not require perfect record keeping habits-it's just simpler that way. 

For interest payments, medical expenses and so forth, you can reconstruct records by securing a statement or affidavit from the parties involved. Or prove the expense by reviewing your credit card statements even though the receipts are missing. 

If you made charitable contributions above $250, you're required to obtain a receipt by the time you filed the return. So does that mean you're out of luck if you lost the receipt? No. You only have to prove that you had the receipts at that time. A statement from the charity or a photocopy of the receipt from the charity's files is sufficient. 

If an auditor questions your clothing contributions to a charity, you can prove the value by itemizing the articles donated, their dates of purchase and prices paid. Show the examiner a pattern of clothing purchases to indicate the level of prices you normally pay. 

When statements from involved parties are lacking, try to collect facts that prove a deduction. You may have a date book or a diary that indicates you attended a seminar and incurred travel expenses. In the case of a casualty loss, get a copy of a police report to prove the loss. Will the auditor go for all this? Probably. Auditors typically give you the benefit of the doubt if your secondary proof is orderly and it appears you have honest intentions. 

Source: Research Recommendations 

Caution  Do not adopt any of our recommendations without consulting a tax professional