The IRS will not tell you this, but you can avoid quite a few tax tangles by setting up your business as a partnership, LLC or an S corporation, rather than as a sole proprietorship.
Not well known but sole proprietors are preferred IRS audit targets. According to the latest statistics, more than 4% of taxpayers filing Schedule C (Form 1040) returns get audited. Compare that with less than 1% of returns for small businesses that have gone to the trouble of incorporating. Partnership tax returns have an audit rate of just about 0.5%. Example: If your spouse is active in your business, form a partnership with him/her and file a partnership return, Form 1065, US Partnership Return of Income, instead of a Schedule C. You’ll reduce your audit exposure by almost 90%. Apparently he IRS does not expect big payoffs from partnership audits.
Did you know that sole proprietors who claim home office deductions hold up two red flags for the IRS?! They must file a separate home office deduction form, Form 8829, Expenses for Business Use of Your Home, and attach it to a Schedule C. Both Schedule C and Form 8829 attract IRS attention – especially if filed with the same tax return. If incorporated, however, either as an S corporation or a C (regular) corporation, you can take home office deductions without filing Form 8829. For instance, you can put the business portion of your electric bill down as a corporate expense. The same is true if you report business expenses on a partnership return. Assuming you meet the criteria for home office deductions (principal place of business, regular and exclusive use), by incorporating or forming a partnership, you can legally take these deductions without drawing attention to your return. To reduce the visibility for an audit you can eventually decide not to use any home office deductions. Do the math. Also ask an accountant for advice.
S corporations avoid much IRS scrutiny, too. One advantage is that people who pay income to the business don’t have to file Form 1099s with the IRS when they deal with an S corporation. By contrast, Schedule C filers get 1099s from anyone who pays them at least $600 in a given year. A copy of these 1099s goes to the IRS. By electing the S corporation status, you’ll have fewer pieces of paper with your name on them floating around IRS files. When you do business as an S corporation, you can pay yourself a “reasonable salary”–an amount that the tax code does not clearly define. Amounts earned beyond your reasonable salary are corporate earnings. Even though corporate earnings are subject to income tax, you won’t have to pay Social Security and Medicare tax on them.
Also make sure to get a tax payer ID for your business and not to use your personal social security number. It will reduce visibility of your own tax return a little bit.
All the things mentioned here will not guarantee that no audit will come down to you, but it eventually helps to reduce the risk of being audited by the IRS.
PS: The advice in this article could eventually be incorrect at the time you read it. Laws can change and so does the IRS. Check with a tax lawyer or an accountant if necessary. We cannot be held responsible for ugly situations based on this article.