The Self Employment (Schedule C) Tax Audit is the examination of tax returns of self-employed taxpayers. These audits are not restricted to taxpayers whose only income is from self employment. These audits or examinations include audits of tax returns of all taxpayers that have self-employment income. Self-employment income is usually reported as a result of receiving a Form 1099-MISC from a payor rather than receiving a Wage and Tax Statement (Form W-2).
Your likelihood of being audited where you report income on a Schedule C, Profit or Loss from Business, is far greater. Most audits today are conducted by mail (correspondence audit), where the IRS provides you with a letter indicating that you may have under reported income from self-employment, or less frequently, questions the accuracy of expenses you have reported on your tax return. In some cases, the examination is more comprehensive whereby the IRS informs you that the examination may require an office visit or field examination by an IRS examiner.
Red Flags and the Selection of Tax Returns to be Audited
The most common self-employment (Schedule C) examination results where third parties have reported self employment income on Form 1099-MISC and it appears that you may have omitted this information from your tax return.
A second identification technique used by the IRS in examining self employment income is the analytical review of expenses you have reported. Where any or all of the expenses you have reported appear to be too great, your return may be selected for examination and you will be asked to provide the supporting information of these expenses. The IRS may compare the expenses you reported to other taxpayer returns that are similar to yours, or compare the expenses reported as a function of the income you earned, or may compare the expenses you reported to amounts you have reported in previous tax returns filed.
Finally, your return may be selected for examination where you have reported losses from self-employment income. The loss you have claimed may be relatively large, or more commonly, you may have reported continuous losses from self-employment for several tax years whereby the IRS may wish to make the determination that your losses are indeed self employment losses and not hobby losses, which are non-deductible. Your Schedule C income may be re characterized to hobby income if you claim losses for more than three years in a continuous five-year period. If your Schedule C income is classified as hobby income, any Schedule C expense you claim is disallowed and income tax will be assessed on the entire amount of hobby income.
The Likelihood of Audits on Self Employed (Schedule C) Taxpayers is Greater
The audits or examinations of self employed taxpayers have a far greater degree of success by the IRS. The IRS’s National Research Program estimated that unreported business income by sole proprietors accounted for $68 billion (or 20 percent) of the $345 billion tax gap. The IRS estimates that as many of 70% of taxpayers who report net losses on a Schedule C have artificially inflated expenses to create losses.
If you’re reporting losses on your Schedule C every year (especially for three or more years in a row), you might catch the attention of the IRS. The IRS knows that self-employed individuals who file a Schedule C have more of a tendency to co-mingle business and personal expenses or to incorrectly treat personal expenses as business expenses in an attempt to hide taxable income. Self-employed taxpayers generally fail to keep detailed, accurate and complete accounting records that are required by law.
In an office or field audit, the most common expenses successfully reduced by the IRS include the automobile expenses, meals and entertainment and home office deduction. Reporting wages or contract labor expenses to others must be supported by Wage and Tax Statements (Forms W-2) or Informational Reports (Forms 1099-MISC) or will be disallowed.
IRS Audit Techniques of Self Employed (Schedule C) Taxpayers in an Office Examination
The least intrusive examination is the correspondence examination in which you receive a letter from the IRS indicating that you may have under reported self-employment income or overstated certain associated expenses on your return. Other less-fortunate taxpayers will receive a request to attend a meeting at the IRS office to examine their tax return, or receive a visit at their business location from an IRS examiner.
The Internal Revenue Manual (IRM 4.10.4.3.3) outlines the general audit techniques to be used in an office examination. The examination of your tax return may consist of any or all five (5) major parts (a financial statement analysis, interview, tour of the business, internal control assessment, reconciliation of income, gross receipts testing, bank analysis, business ratios and e-commerce or internet use).
How to Successfully Win in the IRS Examination Process
If your tax return is being examined in an office visit or field examination by the IRS, the hiring of a licensed, knowledgeable, experienced, professional is most strongly recommended. Being successful in defending yourself against the IRS requires a thorough understanding of tax law, IRS procedures, accounting and preparation.
Understanding the techniques used by the IRS is highly technical. A Taxpayer Resolution Advocate can help you prepare in gathering the information you will need in support of your income and expenses reported on your tax returns. This is no time to try to “do it yourself” as you’re in over your head and you need affordable, professional help. Bringing your friend or brother-in-law to the interview as your advocate will not help you. Going back to the guy who prepared your tax return may not be the best choice.
The key to winning in an IRS audit is in the preparation. Gathering information and preparing records necessary to support your expenses and any questionable position you have taken on your return. You need to be prepared, not only to defend your position, but to assess and quantify whatever exposure you may have, but your payment options should you be assessed additional taxes, penalties and interest as a result of the examination.
It is important that you do not lie, cheat, steal, or make up documentation that you may not have. This will surely get you into much more trouble than its worth. If you overstated your expenses, be prepared to pay taxes that may result. If you just don’t have all the records required by law to support your expenses, you may be given a break if you have some of them or if the expenses reported appear to be reasonable and customary given the nature of your business. Get lazy and not gather the information required and you will most likely be assured to fail.
Dealing with the IRS Examiner
You should almost always be represented by a professional and not attend the IRS examination yourself without representation. In most cases, your Taxpayer Resolution Advocate will recommend you do not attend as you are not required to do so and unfortunately may “trip up” or change the focus of the audit to something other than what is in your best interests. You have certain rights as a taxpayer which include professional representation and the right not to be present at the examination.
However, in limited cases, your Taxpayer Resolution Advocate may ask you to be present in the examination. This is usually done where your presence is beneficial to your case. When you are present, act professional.
- Treat the examiner with respect. Do not get angry, emotional or defensive (the IRS examiner is only doing his job).
- Dress appropriately to indicate respect to the examiner. Do not overdress, or wear expensive jewelry. Business attire is required. Do not dress provocatively.
- When asked questions, respond appropriately and do not offer additional information that you’re not being asked. If you don’t know the answer, say so. You can always ask the examiner to come back to a question or offer to provide an answer at some later date if you need to check your records. Be truthful and honest.
- Do not provide conflicting information.
- Don’t try to make friends with the auditor. This guy is there to “hang you” and don’t ever forget it.
- Don’t offer to meet the auditor at your house or place of business. You are not required to do so and this can only hurt you.
- Do not compare yourself to your friend who cheats on his taxes and has never received an audit letter. This will only get both of you in more trouble.
- You may be asked to come back again in certain circumstances. In most cases, you should respectfully decline unless advised otherwise, directing future inquiries to your Taxpayer Advocate.
Closing the Examination Process
Once the examination is completed, the examiner’s work will be reviewed by more senior IRS personnel for accuracy and completeness. Any questions or incomplete information will be sent to you in generally less than two weeks after.
After all remaining questions are answered, your file will be reviewed and a closing letter indicating the IRS findings and proposed adjustments will be presented to you and your representative.
If you do not agree you may request a conference with the manager assigned to your case, you may appeal the decision before an independent IRS employee or may take your case to court. In most cases, you can reach a mutually acceptable position with the IRS examiner and will be asked to sign a closing agreement indicating your acceptance.
Allow approximately 4 weeks thereafter to close the Audit and pay any amounts that may be owed. Addressing your inability to pay additional taxes is not within what the auditor can do. The auditor is there to assess any taxes you may owe. The payment of any additional taxes is handled by a different person.