While the IRS maintains that audits are largely random, in truth there are “triggers” which raise a red flag to the IRS and one of those triggers lie in the classification of “self-employed.” The IRS claims that the majority of tax cheaters happen to be self-employed, therefore this group gets special attention and are almost always looked at harder than regular wage earners. The IRS employs some 47,000 workers, and the largest division in the IRS oversees tax returns from the self-employed and small business owners. Many small business owners feel they are largely “off the radar,” since their business doesn’t make that much yearly income. Don’t fall into this trap!

Whether your business makes $500,000 per year, $35,000 per year, if you have been foolish enough to cut any corners you run the risk of being audited—or worse, being under criminal investigation. During such an investigation, the IRS has no trouble getting their hands on your bank and other financial records and their auditors are trained to find unreported income. In fact, should you be audited, you will be asked to prove whether all your income or your businesses sales and receipts are properly documented. If you claimed any type of personal living expenses as business expenses, it is a pretty sure bet an auditor will catch such misclassifications. If your lifestyle obviously exceeds the amount of income you have reported then you will be asked to explain, and if you claimed substantial business entertainment expenses or wrote off travel expenses which was not truly business-related, expect repercussions.

For the self-employed, interestingly enough the majority of audits are directed at artists and musicians, however the IRS will look closely at the address of any self-employed person. Why you ask? An individual with a Manhattan address who is claiming to make $20,000 per year will automatically be flagged. The IRS is well aware of the cost of living across the nation, so don’t assume they won’t know that you are living in a high-end neighborhood while turning in very little income. Farmers are another group which gets “special” IRS treatment after one study undertaken by the IRS found that less than 25% of income earned by farmers gets reported. Plumbers, electrician and those in the construction industry will also be subject to special scrutiny by the IRS. The agency is well aware of what the average plumber or electrician makes, so if you are turning in $25,000 per year, you are risking an audit.

The past decade or so has seen the level of computer systems for the IRS increase significantly allowing the agency to more easily extract unpaid taxes from the self-employed and small business owners. More audits are routinely performed; in 2009 approximately 1.5 audits were directed toward those making less than $200,000, while only 29,000 audits were directed at those earning more than a million dollars a year. This should tell you that that even though you may feel like “small potatoes,” unworthy of IRS scrutiny, the IRS feels differently.

If you are a self-employed taxpayer or a small business owner, first get professional help sorting out your taxes and if you have any doubts about the legitimacy of deductions or other tax issues, consult a knowledgeable tax attorney sooner rather than later.

The extreme complexities of the United States tax code make it no surprise that a large number of small businesses make honest mistakes on their tax returns which can end up costing them plenty. And, no matter how unwitting that mistake might have been, count on receiving no mercy from the IRS. There are several common mistakes which you can avoid, thus lessening your chances of being the target of an IRS audit of your small business.

Although the IRS does not require that you save and submit receipts for meals and entertainment which cost less than $75, keep every single receipt anyway. Not only should you keep the actual receipt, make a record documenting the date, where  you were when you incurred the expense, whether there were people with you, the business purpose of the receipt and the business relationship between you and those who were with you. While a credit card receipt may have your name, the date and address of the restaurant, go the extra mile and write out the purpose of the meal or entertainment. Make sure you have a secure place you keep all receipts and documentation, and whatever you do, don’t wait until it’s time to file your taxes to record that year-long documentation thinking you will remember the circumstances—you won’t.

Any office equipment such as computers or office furnishings are considered capital expenditures and must be depreciated rather than simply deducting the equipment on your tax return as an office supply. If the IRS decides you deliberately mischaracterized the equipment they may deny your deduction altogether. If you, like most small business owners, sometimes use your personal credit cards or cash when buying business items, make sure you keep close track of those costs, submitting them for reimbursement to your business.

Many small business owners get into trouble with their automobile deductions. Remember, you can either take the standard mileage deduction or you can deduct actual auto expenses but you can’t do both. You can go from one method to the other from year however this may skewer your automobile depreciation amount. If your vehicle is owned completely by your business, then you are allowed to deduct all auto expenses, however you ever use the vehicle for personal use, then this is considered taxable income to you—or the employee who uses the vehicle.

The IRS has recently reduced their number of audits on those who make less than $200,000 per year and have shifted their primary focus to those who operate small businesses. In fact, the IRS currently audits around 4% of small businesses, with a concentration on cash-based businesses such as those in the construction industry, bars, restaurants or mobile food vendors. If the business is a partnership or S-corporation, there is much less audit risk however you should consider all aspects of incorporating aside from potential IRS benefits.

The biggest trap which small business owners fall into is mixing personal and business use of assets and deductions. Remember—the IRS will contend that all assets and deductions are personal unless you have meticulous records proving otherwise. Should you find yourself in trouble with the IRS because of honest mistakes you’ve made with your business returns, don’t waste time—consult with a knowledgeable tax attorney as soon as possible.

Generally speaking you – or any person – have a 1 in 200 chance of being audited. This risk increases to 1 in a 100 if you make over $100,000 per year. Thankfully for most of us, the IRS has been forced to cut staff which means your odds of being audited just got a bit less likely. Even so, there are certain items in any tax return which the IRS considered “red-flags” as far as audits go. The number one red-flag is when it appears that your income doesn’t quite mesh with your lifestyle. The IRS routinely compares your stated income to your return from last year. Should there be a sizeable drop in income they may assume you are hiding money. They may also look at a huge mortgage as compared to your reported income and wonder where you are finding the money to live in such luxury. In other words, while minor variances are probably of little interest to the IRS, should you claim to be supporting six children and live in an upscale neighborhood on a stated income of $18,000 per year, you will likely have some serious explaining to do.

Cash Payments and Family Members as Employees

If you have your own business and hire your family members, you may have just raised another red flag. Of course hiring family members is not illegal, but many of the self-employed do it as a way of distributing money to their family while decreasing their overall tax liability. So, while you can certainly hire qualified family members to help out in your business—and pay them as you would any employee—you can’t distribute payroll to those who don’t actually work for you and you must always keep accurate and up-to-date payroll records.  The next IRS red flag comes when you work in a profession which the IRS knows is often paid in cash. Unfortunately, whether you cheat on reporting your cash income or not, the IRS may assume that you do. If you work in a cash industry, then you may as well get ready to be audited at some point so keep meticulous records and, ideally, seek professional tax preparation advice.

Alimony Payments, Business Expenses and Overseas Income

If you receive alimony or spousal support payments those payments must be reported as income and if you pay spousal support you may or may not be able to claim a deduction for the money. The thing to keep in mind is that your return and your ex’s return must match up, or the IRS will step in. When you run your own business, you may find the ability to claim deductions at tax time a truly wonderful thing. Be aware, though, that common sense must be exercised at all times. Particularly in the area of your business vehicle, keep your deductions at the sensible level. Keep an accurate log of the driving you do for your business and only deduct that mileage. You may also raise IRS red flags if you show your business has lost money for several years in a row or if you have overseas income.

If you have doubts about your tax returns or if you think you are about to be audited, it is definitely in your best interests to speak with a highly experienced tax attorney who can steer you in the right direction and help you through an audit.

Perhaps you find yourself in the unenviable position of being audited by the IRS and many of the deductions you claimed are being challenged. If you are unable to claim your legitimate deductions through lack of receipts or documentation you may find that you owe substantially more in taxes and may even owe penalties and interest. Even though you may have lost receipts you are allowed to use an affidavit in order to prove the deductions—even though the IRS may not tell you this. While the IRS wants people to think they are not allowed to claim a deduction without the paper to back it up, in most cases this is just wrong. In some cases taxpayers may even have a canceled check but are still told it is simply not good enough.

It is critical that taxpayers know that oral testimony—your word of honor—can be legally sufficient to prove a deduction. You will be required to back up your word with a written statement, signed under penalty of perjury, that the deductions you took were correct and accurate. Such an affidavit—so long as it is plausible and uncontested must be accepted by the IRS thus allowing you to claim your original deductions. Now that you know you can survive an audit even if you are missing receipts, here are some additional tips for getting through the trauma of an IRS audit.

Tips for Sailing Through an Audit

Even if your tax return was all on the up and up, you may still be targeted for an audit. The primary way to sail through an audit with flying colors is to above all, be prepared. In other words, simply assume you will be audited every time you file a tax return. Keep receipts religiously and make notes of your deductions throughout the year rather than trying to remember it all on April 14^th. If you receive a notice for audit respond as quickly as you can. You generally have thirty days in which to respond, but doing it more quickly can help you turn the auditor into an ally.

The audit notice should tell you which items on your tax return are being looked at, so prepare copies of all necessary documentation to bring to your first meeting. Never, ever give the auditor originals as you may never see them again. Don’t bring more than you have been asked to bring, however, or you could be opening the door for further questions. Answer the questions you are asked and produce the documents requested—beyond that exercise your right to remain silent as much as possible. This is not because you have anything to hide, rather simply to keep this time consuming task down to a minimum. If you have received a CP2000 letter this is the very simplest type of audit, sometimes known as a mail-order audit because no in-person meeting is necessary and you are only required to send in requested documentation.

The Auditor is Not Your Friend

Any time you are notified of an audit remember that while you should always be polite and friendly to the auditor, they are not your friend. At the end of the day their job is to ferret out tax fraud and they may have already identified you as a potential tax cheat. Remember, however that you do have rights and they may not be violated even by the IRS. The IRS is not allowed to intimidate you and if you have a deduction that is legitimate and rightfully yours, don’t let the auditor disallow it simply through lack of a receipt. In some cases it can be a good idea to consult a tax attorney prior to your audit to discuss any concerns you might have regarding deductions or what you should expect and what you should say to the auditor.

If you find yourself in the unenviable position of owing more taxes than you can pay, then it is possible you may be eligible to settle your federal tax liabilities by submitting an offer in compromise to the IRS. The amount you will offer will be less than the full amount due, however in order for the IRS to consider your offer you will have to meet certain criteria. Primarily the taxpayer must show—to the satisfaction of the Internal Revenue Service—that he or she has no way of paying the taxes owed or does not actually owe the taxes claimed. After 1992, when Offers of Compromise were widely frowned upon, the IRS decided that collecting some money was preferable to collecting none. Rather than settle on an installment agreement which could drag out potentially for years, the IRS can decide to cut their losses and take what is theoretically collectible as soon as possible and with the least amount of financial burden to the government.

Most cases of Offer in Compromise are based on the taxpayer’s inability to pay the taxes in full. Any time the IRS takes a look at a taxpayer’s financial condition and determines they will likely never be able to collect the full amount then the taxpayer can negotiate an offer that reflects the amount of equity in the taxpayer’s assets plus the amount the IRS believes they would be able to collect from future income. While there are certain cases in which the taxpayer feels the IRS has billed them an erroneous amount, unfortunately these are rare. Still, an Offer in Compromise can be used if the taxpayer couldn’t defend himself against an IRS bill yet has discovered additional evidence which proves the amount claimed is not correct. Finally, should the IRS believe a settlement would promote effective administration of taxes, they can require the taxpayer to explain any exceptional circumstances, showing either that paying the taxes in full would create a financial hardship or that such payment would constitute an unfair situation.

Pros and Cons of Accepting an Offer in Compromise

Of course there is usually a downside as well as an upside to most situations, and agreeing to an Offer in Compromise is no exception.  The benefits of accepting an Offer in Compromise include the fact that the IRS will hold off on attempting to collect money from you while they are considering your offer. Secondly, once an offer is accepted and completed, any tax liens against you will be released. Finally, an Offer in Compromise ensures the taxpayer can avoid bankruptcy, even reducing taxes that would not have been considered dischargeable in any case during a bankruptcy petition.  The downside of accepting an Offer in Compromise include the fact that the taxpayer must fully disclose all their financial information to the government—something few of us would like to do. Some tax benefits may be waived once the Offer is accepted, and a federal Offer in Compromise does nothing to resolve any other debts or taxes due to your state.

How Much Can You Reduce Your Tax Liability?

As stated, the IRS will first determine the worth of the taxpayer’s resources less other money owed which has priority over the Federal tax lien on a discounted basis, then will add in a determination of the taxpayer’s ability to make future payments.  In evaluating the taxpayer’s future income prospects, the taxpayer’s education, profession, trade, age, experience, health and past and present income will all be considered to make a determination. One formula the IRS may use to determine your future income is to subtract the necessary monthly living expenses from your monthly income over 4-5 years. These figures added together will equal what the IRS will be willing to accept for the amount you owe. Remember, that once you have entered into an Offer in Compromise Agreement with the IRS you absolutely must remain current on all tax obligations for a period of five years or you risk having your agreement revoked. It can be to your advantage to have a tax attorney help you navigate this type of agreement so you can be sure  your interests are being protected.