Business codes and their implications.
When you file personal (filing as a sole-proprietorship), corporate, or partnership income tax returns there are numerous ways that the IRS uses information to track your business. The social security number, federal employer identification number, date of business formation, and also your business activity code. As I will explain the use of the wrong code can lead to examination by the Internal Revenue Service.
Suppose for this example that you operate a plumbing business, in any of the above mentioned entity choices. The business activity for a plumber is 238220. This six-digit code is based on the North American Industry Classification System (NAICS) and can be found on the IRS website at www.irs.gov. The IRS will use this code as a reference for all of the plumbing companies that file income tax returns. They have a set formula for a basis for the type of and amount of expenses that will be reported on these tax returns. A plumber will have a different type of expenses than an electrician, a drywall installer, or a landscaper. The ratio of certain expenses, such as cost of goods, labor, small tools, and travel will be different for a plumber than other business types. If you as a plumber use a code for a drywall installer (code 238310) and have a lot more in sub-contractor or small tools expense than a plumber normally has it will cause the IRS program to take notice. If you have more in supplies (as a percentage of overall expenses) than all the other plumbers using the correct code you will have another item to notice.
The IRS has a program that keeps score of these noticeable differences and when there are enough of them your return will be selected for a cursory review. (This is the DIF SCORE-Discriminate Income Function) Based on this review the IRS will either see the error in the code used and close the review, or see other items for consideration and send the return to the field for an agent to review.
Before you file in future years review your business code and be sure it represents your business. Review the IRS Publication for small businesses for other important information regarding your business and items the IRS will consider when reviewing your return.