Sole Proprietors Likely to Be Focus of IRS Audits

The Internal Revenue Service (IRS) released data last week based on random audits of 46,000 tax returns for 2001 that showed a tax gap of about $354 billion a year. IRS Commissioner Mark Everson said, according to Bloomberg.com, that most of the noncompliance occurs in businesses where there isn’t automatic reporting of information to the IRS, such as sole proprietors who report income and deductions on Schedule C.


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Sole proprietors, independent contractors, self-employed workers and others accounted for $68 billion in missing taxes, the IRS said, the Associated Press reported.

“That is a very significant noncompliance rate,” Everson told reporters. “We do not have specific conclusions as to how much of this is willful or confusion.”

Sole proprietors are at least 10 times more likely to be audited this year than other business entities, dailybreeze.com says. Last year, with more enforcement personnel available, the IRS audited almost twice as many individuals as five years previously, blackenterprise.com says.

Daniel Kehrer, writing in dailybreeze.com, advises sole proprietors to consider making their businesses corporations or LLCs to avoid audits and to hire a certified public accountant for tax advice.

What are the red flags the IRS will be looking for in sole proprietor returns? Kehrer says that underpayment of quarterly estimated payments, or late payments, could be significant to the IRS. Sole proprietors should also watch their income-to-deduction ratio. If this ratio exceeds 52 percent, an individual is more likely to be audited, according to tax attorney Stephen Fishman, Kehler reports. Finally, beware the home office deduction – a prime IRS deduction, he says, and avoid vague expense categories, such as miscellaneous.

Kevin McKeon, an IRS spokesman for the metro area, was asked by the New York Daily News what red flags the agency looks for and “how it determines who would get audited.”

McKeon said that common errors that tip off the bureau are invalid or incorrect Social Security numbers for the filer or dependents, math errors, and incorrect bank deposit numbers or routing numbers. Returns will get special attention when the taxpayer fails to sign and date the return or fails to attach W-2s.

Generally the IRS assigns a numeric score “somewhat like a credit rating” to each return, the Daily News says, and thereby determines which returns will require more review. But “the major reason of all audits is illegal tax shelter," McKeon said, “or the use of offshore credit cards.” “Sometimes we (the IRS) look at an industry and if you work in that industry you might be audited,” he added.

Returns prepared by computer are neat and less likely to have math errors experts agree. Taxpayers should prepare their returns early, but should not file early, ABC News says.

McKeon advised using only reputable tax preparers, those who have the title “enrolled agent” meaning that they’ve taken a qualifying test from the IRS.

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