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The IRS states that most people who are picked for audits are selected by computer analysis, an entirely random affair. The number of audits is low, and your chances of an audit are actually slim. Plus, a knock-on-the-door visit from the IRS is even more rare- only a little over nineteen percent out of one percent of all taxpayers came face-to-face with an auditor in 2005. In fact, you may have already been audited if you ever received a letter from the IRS that informed you about a miscalculation on your return. So, audits are not life threatening, but they can be horrid if you're convicted with criminal activity.
If you're self-employed, your risk for audits may be higher because the IRS feels that self-employed individuals are more likely to cheat on their taxes. With the ability to take cash payments and to avoid a W-2 paper trail, the self-employed can fudge on their returns.
You can lower your risk for an audit when you're honest about your income and your deductions; however, even a minor change in your income or lifestyle might trigger an audit. How can you avoid an audit, or worse, a criminal investigation? If you're a sole proprietor, an independent contractor, a member of a partnership, or are otherwise in business for yourself, the following tips might help you to avoid a visit from the IRS:
Math Errors
Math errors include, but aren't limited to, simple addition, subtraction and multiplication mistakes. You can avoid most simplistic errors when you use a calculator. Plus, IRS computers automatically correct math errors where you claim deductions that exceed limits set by the tax code. But if your return contains too many errors, this sloppiness may lead to a full audit.
If you ever received a letter from the IRS that informed you about a corrected return, you've received a "correspondence audit." This letter may hold good news (a correction may have triggered a higher refund) as well as bad news, so don't fear these letters if you know that your return was correct to the best of your knowledge.
Failure to Sign
This is a simple error, but one fraught with suspicion. If you forgot to sign your name on the return, what else did you forget? This is what the IRS wants to know.
Overestimating Donations
The IRS makes it easy to deduct donations on your tax return. The problem, however, is that most people overvalue those donations. Additionally, clothing and household items donated after August 17, 2006 must be in good used condition or better. To be on the safe side, make sure that your business equipment donations are also in good condition.
The basic rule of thumb for material donations is to look for a fair market value. In other words, what would that item sell for under normal circumstances? Generally, the IRS believes fair market value on donated goods lies between one and thirty percent of the original purchase price. But, if you plan to donate a large-ticket item such as an automobile, you can cover your assets with a letter from an appraiser. In fact, you must have an appraiser's letter on file for any item valued over $5,000. See Investopedia for an easy-to-understand list of charitable deductions.
Underreporting Income
You can't outsmart the IRS because they can lay claim to all your accounts for investigation if they believe you've underreported your income. This is especially important to understand when your business operates on a cash-only basis.
Cash Businesses
Don't think you can hide large or even multiples of small cash transactions from the IRS, especially over a number of years. There are three main ways to get caught in this trap: 1) if you work as a waiter or waitress or in some other job where you make tips as part of your income, especially when your income potential is high (think Los Vegas, for instance); 2) when your lifestyle is larger than your bank account (more charitable contributions than income, believe it or not); and 3) when someone who pays you in cash is audited. That last cash trail can be traced to you.
You must report any cash transaction over $10,000 on IRS Form 8300 by the 15th day after the date the cash transaction occurs. Failure to file this form on time can result in criminal investigation.
Home Office Deductions
Many small business operators refuse to deduct their home offices, as this deduction is difficult to calculate and presents an open door for an audit. However, if you have a room that is used solely for your business, there's no reason not to deduct this expense. As with charitable contributions, don't overestimate your expenses and keep good records on the portion of utilities, insurance, etc. that it takes to keep that room functioning. The IRS will accept simple math corrections if they ask you about this deduction, but they'll clamp down on anyone who uses a room as a deduction when it's used for any purpose other than business.
The IRS offers Publication 587, Business Use of Your Home Office, for your edification on this deduction.
Income Discrepancies
If you live in the Hamptons and you declare an annual income of $30,000 when your neighbors claim $300,000 or more, your return will set off IRS alarms. On the other hand, if you operate a business and you never deduct certain expenses, that omission might trigger an audit as well. In other words, your income should fit your lifestyle and your neighborhood. Plus, a small business owner is expected to write off certain expenses (like transportation expenses if you travel for business), so don't be surprised if your continual refusal to write off a deduction sparks some interest.
Granted, if you reside in a carriage house in the Hamptons and you work as a nanny for the carriage house owner, your $30,000 income might be valid. Plus, if you continue to work out of a closet at home and it's not worth the effort to claim the deduction, the IRS will understand. But, you'll need detailed and organized records to explain these oddities. If you're ever audited and you bring your wrinkled receipts stuffed in a shoebox, the IRS will wonder what you're trying to hide.
Income Threshold
If your business is successful, the IRS might want to know more about you. There's nothing you can do about this one other than keep good records and enjoy your success, as the IRS might look harder at incomes over $100,000 than those under that amount.
Change in Lifestyle
If you paid out a large sum this year for medical expenses, or if your income suddenly pushes you into the next income tax bracket or higher, you might expect some IRS attention. Once again, keep good records and keep them organized.
On another note, if your income suddenly increases, look for valid ways to reduce your taxable income through a self-employed retirement account or two. The IRS encourages saving, believe it or not, as long as you're honest about what you owe the government.
Partnership/Trust/Tax Shelter Risk
The IRS looks harder at increased income, and they also scrutinize individuals who own share in a limited partnership, control a trust, or who partake in any tax shelter investments. If you lean toward these interests, then you know the paperwork is already enormous. Take into consideration that the IRS will want to look at everything if you're audited.
Family on the Payroll and Payroll Taxes
Pay attention to tax laws about hiring a family member for your business, as they differ from those laws for hiring non-related employees. Along the theme of employees, make sure that you make your payroll tax payments on time. If you don't, this delay will trigger unneeded attention.
Employees or Independent Contractors?
You might hire full or part-time employees, but independent contractors might make more sense. If you don't know the difference between an employee and an independent contractor, you might dive headlong into an audit and a possible lawsuit from a disgruntled person who believes that he or she was hired as an employee rather than as an independent contractor.
Generally, a worker who performs services for you is your employee if you have the right to control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed. If an employer-employee relationship exists, it does not matter what it is called. The employee may be called an agent or independent contractor. But, if you don't withhold taxes, Social Security or other payments from the paycheck, then that hired person may be an independent contractor, not an employee under common law.
As you can see, the difference is a fine line, so if you hire people to work for you, make sure you know what you want and make equally sure that you maintain that goal through appropriate actions. If not, a hired person may be able to file suit against you for benefits such as life insurance, etc. That may be worse than an audit!
Hold Onto Records
The IRS can audit you for three years after you file your return, but most returns are audited within eighteen months or less after filing. This latter time frame is enough for the IRS to review your return and to request the appropriate substantiation before the statute of limitations expires (usually three years). So, be sure to hold onto your old records; otherwise, you'll fail to convince the IRS about your honesty. Once that three-year limitation has passed, your expenses are insulated from IRS scrutiny.
Follow the Law
One of many theories about timing your tax return claims that the later you file, the less likely your return will be audited. While this suggestion might hold some merit, your chances of an audit are basically the same, no matter if you file early, late, or even if you file an extension. The IRS cannot persecute you if you maintain proper records and if you don't break laws.
Conclusion
You have more things to worry about other than an audit when you're self-employed. So don't worry about the IRS as long as you keep accurate and organized records and as long as you pay your taxes on time (or file a timely extension). Most likely, the IRS will want to satisfy a simple curiosity about a red flag. If you can supply an answer, you can avoid a full audit. So, don't delay in your response to an IRS inquiry.
If you are selected for a full audit, you might want to hire a representative to talk for you. If you can't afford a professional, you can visit the IRS Publication 4134 [PDF] and pick a representative from the low-income taxpayer clinic list.