Are you Self-Employed? If so, the IRS has you in their cross-hairs. Your
chances of being audited are THREE TIMES HIGHER than the average worker
bee. You see, if you work for an employer and receive a Form W2 at the
end of the year, the IRS gets a copy of this document. If what the
employer says you made and what you say you made matches and you have no
other sources of income, you get as close as possible to being audit
proof, although everyone is subject to being audited. However, if you
are self employed, the IRS believes that you are most likely cheating
the system, either intentionally or because you don’t fully understand
the tax codes. The IRS believes you may not be declaring all your income
(think about cash receipts) or over inflating your business deductions
with personal expenses. So the IRS audits you and your business. Fun right?
Here is what the IRS does when it examines the tax return of a
self-employed person:
They will first ensure that all income is declared. The first line on
the business tax return or Schedule C is Gross Receipts. If yours is a
service business like a graphic artist or web designer you will likely
receive Form 1099 at year end from your customers. The IRS receives
copies of these 1099s, totals them and compares the total to what is
declared on the Gross Receipts line. So you too should total all 1099s
you receive for the year and make the comparison yourself prior to
filing the tax return. If your 1099s total $200,000 and you declare only
$150,000 on your tax return, guess what? You will receive a visit from
an IRS agent! If in your calculation you find an error on a 1099, make
sure the originator files a correction with the IRS and provides you
with a corrected copy. The next step the IRS takes to ensure proper
reporting of income is a comparison of Gross Receipts from the tax
return with total bank deposits for the year. (This will include your
personal bank account). It’s important to define additional bank
deposits that do not relate to sales and keep a record of the details of
the transaction. For example if the IRS sees $200,000 in bank deposits
but you report Gross Receipts of $150,000 the IRS will want to know
where the other $50,000 came from. If you cannot prove a legitimate
source, it will likely assign the $50,000 difference to sales and charge
tax on it. You must prove the bank deposits were not taxable sources of
income. For example, the $50,000 difference may include capital
contributions on your part of $10,000 from savings to help cash flow,
and a credit line advance of $40,000. These two transactions are not
taxable events and if you have canceled checks for your contributions
and the credit line statement as proof, you’re home free.
Second they will ensure that no personal expenses are deducted. Your
taxable income is reduced by the total deduction of all ordinary and
necessary business expenses. Classification of these expenses is a
subjective task open to argument with the IRS. As long as the deduction
falls within those parameters and was also not for an illegal activity
(such as getting a parking ticket while attending a business meeting),
you are fine. Let’s say for example that entertaining customers is
common in your industry because you own a winery. These expenses will
fly with the IRS as ordinary and necessary. However, if you are a
carpenter, you will likely have a very small amount of expense in this
area. The IRS will not expect to see a large deduction for meals and
entertainment and will disallow anything excessive, feeling that you are
likely attempting to write off family meals, meals with friends and
other personal meals such as your lunch. If you have valid deductions
that may be questionable, such as meals, travel, entertainment and
vehicle expenses, you should keep all documentation that proves business
rather than personal intent. Remember, a DETAILED log is important as
well as an independent third party statement that will verify your log.
An example is your mileage log might be very detailed with date,
business purpose and odometer reading, however the IRS has won in court
when a tax payer was unable to produce third party maintenance records
that verified the vehicle odometer reading.
The IRS will look for personal use when touring your home office. The
auditor will measure the square footage to determine if it matches what
is declared on the tax return (yes they will use a tape measure). The
auditor will also check out the space itself to see if the room is used
for personal purposes, like a guest bedroom, and if so, may disallow
that portion of the room. Basically the same rule applies if, for
example, you have business inventory or assets in storage or the
basement. The auditor will tour the location to see if any personal
items are kept there. If so, the amount paid for storage expense may be
reduced and result in a higher tax liability.
No one can guarantee you will never be audited, but a good tax
professional will help you survive an audit.
