IRS loves to audit Schedule C. This form is filed by taxpayers who conduct their businesses as sole proprietors (popularly referred to as “DBA” or doing business as) instead of corporations or LLCs. This includes professionals and independent contractors who receive 1099s as subcontractors (instead of W2s as employees). Sole proprietorships face a risk that’s much greater than wage earners. Here are issues that draw the most attention from the IRS:
1. Employees versus independent contractors – You have personnel who work under your supervision and control at your business location. You do not want to treat them as employees because you do not want to pay FICA, Medicare, and unemployment insurance. Your personnel also do not want you to withhold federal and state taxes. It is therefore quite tempting not to deduct taxes and treat them as 1099 independent contractors instead of W2 employees. If the IRS or EDD determine that your workers are employees, you could be assessed for employer’s share of payroll taxes as well as employees’ taxes that you should have withheld. Ouch.
2. Unreported income – is checked by comparing reported revenues versus deposits. The Service adds all deposits to all your bank accounts and compares the totals with what you reported as gross revenues on your returns. If you deposited $70,000 but reported only $50,000, the IRS wants to know where that extra $20,000 came from. This undeclared excess amount could have come from non-taxable loans or bank transfers. It could also have come from business income that you chose to “hide” by depositing collections to personal or children’s accounts. Remember that auditors are trained to catch these anomalies. They are professionals and will track down this rather basic scheme. They perform a BDA (business deposit analysis) on your business and personal accounts that can easily uncover unreported income. If they become suspicious (or if give them a hard time), they’ll also look at deposits to accounts of your spouse and children. Malo.
3. Personal auto use – do not claim 100% of vehicle expenses. You do use that car for commuting to and from the office, buying groceries, or taking the kids to school, don’t you?
4. Personal insurance – Business-related insurance such as fire and liability coverage on business properties are fine but coverages on personal auto, life, or home are not. Take time to allocate auto insurance among business and personal cars. It also enhances the most important criteria in an audit: credibility. This magic word makes a lot a difference when you are face to face with an agent.
5. Capital expenditures – Some expenses benefit the current year (telephone, supplies) and therefore can be expensed this year. Some expenses benefit future years (car, computers, roof) and therefore should be capitalized and depreciated over three, five, seven years or longer. Agents are on the lookout for equipment with a life of seven years but were expensed in one current year. (TIP: Use section 179 of the Internal Revenue Code to expense equipment—if you need deductions this year)
Caveat: If you submitted an “improved” version of your income tax to a bank for loan purposes, beware. The IRS has a program with banks and the SBA (Small Business Administration) by sampling returns that look cute compared to the universe of average returns. The banks can cooperate with the IRS because you signed an authorization (you may not even know it), along with other loan documents, for them to disclose your taxes to the IRS. Be careful. This is a no-win situation. If you stand behind the improved bank version, it becomes an IRS fraud case. If you stand behind the IRS version, it becomes a bank fraud case. Either way, you lose. Don’t do it.
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Victor Santos Sy graduated Cum Laude from UE with a BBA and from Indiana State University with an MBA. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation in Pasadena, California.
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He has 50 years of experience in defending taxpayers audited by the IRS, FTB, EDD, BOE and other governmental agencies. He is publishing a book on his expertise – “HOW TO AVOID OR SURVIVE IRS AUDITS.” Our readers may inquire about the book or email tax questions at [email protected].