
13 Mar How To Get Your Sole Proprietorship Audited: Red Flags You Need to Know
Afraid of the IRS knocking at your door? Worried about getting your sole proprietorship audited? You are not alone! So many people choose to over-contribute to their taxes because the thought of an IRS Audit strikes fear in their hearts. Do not be afraid! We have compiled a list of some red flags. You will want to watch out for these if you file a Schedule C.
Who typically files a Schedule C on their 1040 tax return?
Are you a subcontractor? Do you have a side gig or are you freelancing on the side of your regular employment? If so, you will receive a 1099-NEC from whomever paid you. Earnings will either be reported against your social security number or against your EIN number (employer identification number). This impacts how two types of business entities file their income (and expenses) on a Schedule C:
- People who own a sole proprietorship, which is an unincorporated business owned and run by one person who is entitled to all the profits but also responsible for all the liabilities.
- People who own a single member limited liability company (LLC). Single member LLC’s are the same as sole proprietorships in that there is only one owner and all the income and liabilities are the responsibility of the single member.
LLC’s and sole proprietorships typically file the business income or loss within their personal 1040 tax return. This means that there is not a separate tax return for the business; rather, the net income or loss is a part of your personal income. Here are ten things you need to watch out for if you are a Schedule C filer so that you can limit your risk of audit:
High Income or Losses
Unusually high income or significant losses compared to similar businesses in the same industry might attract IRS attention. Large fluctuations in income from year to year could also raise suspicions.
Taking disproportionately large deductions and Underreported Income
If you spend a lot of money to write off income, especially in areas of travel, meals, entertainment or home office expense and you cannot back it up with good record keeping, this can raise a red flag. The flip side of this is underreported income. You might ask yourself how people would inadvertently not report all their income? Think of things like cash transactions, online sales, and bartering… if you get a lot of income in one of these ways, it must still be reported.
Large Cash Transactions
Do you like to pay cash for large purchases, as in whipping out hundred-dollar bills from your billfold? If you are conducting significant transactions in cash, this can raise concern. If you are going to receive or pay cash for significant dollar value purchases, you definitely want to back it up with receipts or some sort of proof, verifying the cash paid/received. The form 8300 is for a business owner to report cash transactions greater than $10,000.
Smooth, round numbers
Smooth, round numbers are an IRS red flag. Business is messy! If your numbers are not messy and follow an excessively neat and rounded pattern, it could be cause for extra scrutiny. These smooth round numbers might also signify potential errors to the IRS. Again, you need to have proof/backup/receipts if your spending and earning are all in smooth round numbers.
Frequently Amended Returns
Filing an amended tax return is a big deal because it requires a lot of additional work. If the IRS sees you re-filing with different numbers, it could be a signal of mistakes, errors, or coverups. That is why it is so important to understand the tax deductions and credits that you are applying for. The same can be said about adhering to tax deadlines. Late filings or payments attract penalties and increase scrutiny.
Mismatched Income Reporting
The income on your schedule C tax return is also being reported by the filer who spent that money and this means that you need to carry accurate records for filing. If a third party such as clients or financial institutions are reporting significantly different amounts than on your return, this can be a problem. Accurate reporting is a must.
Home Office Deductions
Home office deductions can be a big source of scrutiny for the IRS, because so many people do them inaccurately. In this day and age of work-from-home, you must really understand what you can and cannot write off on your taxes as a home office deduction. There are two ways to do home office deductions:
As a percent of rent, real estate tax, utility bills, phone bills, insurance bills and other costs
A Standard Deduction of $5/square foot of space used for the business.
Hobby loss write-offs (for multiple years)
Most definitely, sustained losses draw attention. If you are in business, even as a side gig or as a freelancer, the expectation is that you will start to earn a net profit after you have done it for a few years; otherwise, why would you keep trying? The IRS needs to see a reasonable expectation of profit if the business has been going for many years.
Personal Expenses Mixed in with Business Expenses
What if you mix vacation expenses, luxury items and personal vehicles in with your business expenses? This shows poor judgement and not much separation between spending and earning money. We need to keep our business and personal finances separate. When we are mixing the use of bank and credit card accounts for multiple purposes, it gets messy.
Claiming 100% business use of a vehicle
Is that vehicle left at the office every day with a big and unruly wrap around it? If not, chances are that you might have driven the company vehicle and stopped for a cup of coffee on your way into the office. When you claim that 100% of a typical street vehicle is used for business, you open up a can of worms. And don’t forget it is easy to scan! That 100% use on the company car and none for personal will hop off the screen for an experienced auditor!
Accurate reporting is key to avoid having your sole proprietorship audited
So there you have it – 10 ways for Schedule C filers to improve your chances for audit. If you prefer a less flashy way of filing returns, then you may have gathered that one of the very most important things you can do to keep yourself a little more incognito! And – we cannot stress this enough – you must have accurate reporting. Here’s how:
- Use reliable accounting software like QuickBooks Online!
- Hire a bookkeeper to help you maintain your records throughout the year!
- Save receipts and attach them to your software!
As the owner of a bookkeeping and accounting company, I often wonder how much money we have saved our clients over the years by keeping everything organized and in order. That number is a bit intangible. But ask someone who ended up with an expensive and stressful audit if they wish they had paid for a good bookkeeper to keep things smooth. I’m willing to bet the answer would be a resounding YES!
When COVID-19 hit, our clients were first out of the gate, trying to claim their share of the CARES Act tax credits. To that end, we supported our clients in securing over $100 Million to see them through the pandemic. This money would not have been available if we had not been ready to go with measurable, accurate numbers to fill out those applications. If there is any piece of advice I have for Schedule C filers who want to avoid audit, it is this: Maintain consistency in record keeping!