When you’re self-employed filing a Schedule C with your tax return, your chances of being audited are greater than if you were a wage earner.
This is because the IRS catches many such individuals that attempt to either hide income or write off personal expenses as business deductions. When all you are reporting on your tax return is income from a W2, what’s there to audit? Even if you enter the numbers wrong, the IRS will match it up with the copy it got from your employer and send you a correction letter along with the adjustment. So, with scrutiny of the self-employed on the rise, here are 5 things you can do to reduce the chances of an audit:
1. Use professional software such as QuickBooks
Track the income and expenses of your business with accounting software. Your credibility increases in the eyes of an IRS agent if your tax return is based on professionally-prepared financial statements, especially if maintained by an outside firm.
2. Document sources of all income
If you are audited, the first thing the IRS agent will do is add up all of the deposits from your personal and business bank accounts. If more money went into the bank than was declared on your tax return, the agent will want to know where the money came from and whether or not the income is taxable. If you use QuickBooks for your personal and business books, you will automatically tie out this income, but you still need proof. If the income you record is not taxable (e.g. gifts, inheritances, loans, transfers from personal funds) keep a copy of the check or document that accompanies the income to prove the source is not taxable.
3. Let a professional prepare your income tax return
Self-prepared returns are more likely to be audited because the IRS thinks a nonprofessional has limited knowledge. Tax law is complex. And if you are self-employed, no matter how small your business, your tax return is now a complex creature.
4. Rethink your legal form
Corporations, LLCs, and partnerships are less likely to be audited, but that should not be the sole reason to incorporate. Discuss this option with a tax professional and your attorney before making any changes.
5. Document the Red Flags
You are allowed to deduct all ordinary and necessary business expenses which means thinking in terms of “Would I make this purchase if I didn’t have this business?” If the answer is no, than you more than likely have a deductible business expense. But it’s important to know the rules and to have proper documentation to substantiate the deduction.
Some expenses receive considerably more scrutiny than others:
Automobile expenses
Taxpayers are required to keep a mileage log if they want to take these kinds of deductions, which can be a lot of work. The IRS loves to investigate these because very few business owners will bother with this. Fortunately there are other ways to substantiate the deduction to the satisfaction of the auditor.
- If you use an appointment book or calendar, save it along with your copy of the tax return. A mileage log can be reconstructed from those pages.
- Save vehicle repair receipts as the odometer reading is recorded on them and total mileage for the year can be extrapolated if there is more than one receipt.
- Record your beginning and ending odometer reading in your appointment book on Jan. 1 and again on Dec. 31.
Travel, meals and entertainment expenses
These are also very common when it comes to tax audit scrutiny. Go to www.irs.gov and read Publication 463 to determine what you can and can’t deduct.
- Travel, especially to vacation destinations like Las Vegas or Hawaii should be documented with more than purchase receipts to prove the business intent. Save anything that can substantiate your claim that you were traveling primarily for business; such as flyers advertising the trade show, or the continuing education seminar, or letters from prospective clients at that location in your tax file.
- Write the name of the person entertained and a brief note describing the business purpose on receipts for meals and entertainment.
Home office expenses
These are another red flag for the IRS to take a closer look at your expenses.
- Take photographs of the house and the office area. The photos will serve two purposes: they will show the proportion of the business area compared to the personal living area to substantiate the amount of space claimed as well prove that there is in fact a business area.
- Know the rules: The home office must be your principle place of business and must be used exclusively and on a regular basis for business purposes.
