Misclassifying Transactions

This is one thing that will get you in soooooo much trouble with the IRS!  While the actual audit statistics are low (1.1% for individual tax return in 2011), over a lifetime, especially if you own a business, your chances of being audited are greater.  Therefore, it’s important that your books are accurate BEFORE that happens, so your chances of a penalty are much less.

Scenario:  My client has a construction business.  He has a customer that hasn’t been able to pay their bill, so my client has been trading work for goods from them.  This is fine, so long as it’s recorded accurately.  However, one day, my client left a tip for his customer.  He tried to record the tip as “casual labor/wages”.  How would you have handled this?

My client’s feeling was that the tip went toward his customer’s wages, so it was casual labor.  He knew that casual labor was 100% deductible on his taxes, whereas meals & entertainment is only deductible by 50%.  So he wanted the one that gave him the greatest deduction.

This was incorrect.  Should an IRS agent have come across this, they would have wanted documentation of what the “casual” employee did for the company.  What was the duration of their employment, and other documentation to substantiate why the employee was a 1099 employee versus a regular employee.  And yes, you do need to keep those records!

So what do you do to make sure you’re right?  Be honest.  Plain and simple, be honest.  Call it what it was.  If you aren’t sure, ask your tax preparer or bookkeeper.  The IRS has great information on their website www.irs.gov as well, just search by topic.  If you’re looking for wage classifications, office supply deductions, etc, just search for it.  One word to take note of – states may have different definitions.  Generally, if you follow the IRS’s guidelines, you should be fine.  Again, your tax preparer will be your best resource for you on this.

Next week, my post will be about a related topic – having detailed enough expense categories.