Self-employed (SE) individuals are more likely to get audited than regular employees. The IRS allows for many tax breaks for the SE, making it favorable to own your own business. However, these tax breaks are also the reason that the SE are more likely to be targeted for audit.
Many of the tax write-offs allowed to the SE are abused and either overstated or understated, depending on which is more favorable. The IRS has audited thousands of SE individuals who have abused the system, making it more likely that the SE will continue to be audit targets.
Most SE individuals receive their revenue in the form of cash. They do not receive a W-2 from an employer who then reports that income to the IRS. Their income is self-reported, allowing for potential under-reporting of income. If audited, the IRS would require bank statements and compare the reported income with that of cash deposits. They would also take a look at the individual’s lifestyle to determine whether or not it exceeds the level of reported income.
SE individuals are allowed to take home-based business deductions if they meet certain criteria. This allows them to write-off a portion of their mortgage/rent payment, insurance, utilities, maintenance and repairs on the entire house, creating a significant reduction in taxable income. The home office deduction is based on the percentage of office space in relation to the square footage of the entire house. This number can easily be inflated, creating more of a tax break than is actually allowed.
Mileage for business can be deducted. Since SE individuals maintain their own records for this, it is another reason that they can be audited. Business travel can and often is combined with personal business, disqualifying those miles as a business expense. A standard deduction can be taken, whereby, the miles are reported and the taxpayer receives an allowance per mile, which is then deducted from income. For 2008 reporting purposes, the rate allowed is 50.5 cents/mile from 1/1/08-6/30/08 and 58.8 cents/mile for 7/1/08-12/31/08. The more miles reported for business purposes, the greater the reduction in taxable income. Actual expenses can be taken instead of the standard deduction, where the cost of gasoline, oil changes, repairs and maintenance can be deducted.
Meals and entertainment expense is another abused write-off by some SE individuals. Generally, 50% of meal and entertainment expenses are deductible if they meet certain criteria, making it a potentially large write-off. Some individuals may “talk shop” for a few minutes while at dinner or an outing and justify it as a “business” expense. If the dollar amount of meal and entertainment expense is large compared to the nature of the business in question, the IRS will most likely target that individual.
The following are ways the SE individual can protect him/herself in case of an eventual audit:
1. Report all income. File quarterly income tax statements in order to pay taxes throughout the year in order to avoid penalty at the tax filing date.
2. Only report expenses that fall within the guidelines of business and keep receipts for everything business-related.
3. If claiming a home office deduction, be sure to meet the criteria first, and claim the correct percentage of expenses.
4. Keep good records of business mileage and/or expenses in order to substantiate a deduction.
5. Be careful not to abuse the meal/entertainment deduction. Make sure it is a legitimate business expense and keep receipts.
Always go to the IRS website for current information on what is and is not allowed. Follow this link to the Self-employed Individuals Tax Center.