People who run their own businesses or are otherwise self-employed tend to face greater scrutiny from the IRS. The agency believes that they are more likely to cut corners on their taxes than ordinary taxpayers. As a result, self-employed individuals should be especially careful to report all of their income to the IRS and to refrain from taking inappropriate deductions. These are the two main areas on which the IRS focuses during audits.
If you are audited, the IRS will look through your financial records in an effort to determine whether you properly reported the profits of your business and any major cash transactions. They will review records related to any employees of your business to make sure that you kept up with payroll taxes and that you did not misclassify employees as independent contractors. The auditor will take a close look at any deductions that you have claimed in case you may have improperly classified personal expenses as business expenses. For example, these may involve deductions related to your home, your car, or travel expenses. If you seem to be enjoying a lifestyle that is not compatible with the income that you reported, the auditor may check for unreported sources of income.
Common Areas of Concern in Audits of Self-Employed Taxpayers
You must report any business transactions that involve cash amounts over $10,000 (or cash equivalent transactions over $10,000) by filing Form 8300. This rule is meant to combat money laundering. You can face serious civil penalties for failing to file Form 8300 when required, and a self-employed individual may even face criminal prosecution in some cases.
Even if you do file Form 8300, you may attract heightened attention from the IRS if substantial amounts of cash regularly pass through your business. The IRS may wonder if you have been tempted to misappropriate some of this cash rather than reporting it for taxes. These types of businesses face an elevated risk of an audit.
Finally, any business with employees must make sure to keep up with payroll tax deposits. If you have employees, you cannot use money withheld from paychecks for employee taxes as a “loan,” even if you intend in good faith to eventually repay it. You can incur massive penalties and other costs if you do not make payroll tax payments on time. To be on the safe side, some business owners use a bonded payroll tax service. You might be able to set up this type of service through a special company designed for this purpose or through a bank. The payroll tax service will file returns and make deposits on your behalf. This transfers the responsibility for complying with tax laws from the business to the payroll tax service.