Self employed can face income tax audit in United States either as part of the usual sample testing, or because of certain triggering information related to them that gets flagged by the system during risk assessment of taxpayers. It could be due to unexplained behavior on their part, or due to other factors. Being aware of the process and preparing well can take away the anxiety associated with such a process.

The challenges of tax compliance and administration are highly varied and peculiar in case of self-employed, a fact that often leads to a greater attention on their scrutiny by the tax administrator. This is partly due to flexible means in which self-employed can arrange their business, but also due the inherent problem associated with applying the Simon Hague definition of income in case of self-employed.

In recent times, the IRS has increased its focus on the self-employed and small businesses. A significant proportion of the additional resources granted to the IRS during the Bush era have been used to strengthen the 'Small Business/Self-Employed (SB/SE) Division' of the IRS. Clearly, the taxman views the self-employed as an important target for unearthing tax evasion.

Reasons for Targeting Self-Employed

There are three main reasons why the self-employed are common audit targets.

First is the high amount of cash used in their activities. Most self-employed receive a substantial part of their business payments as cash, thereby creating an easy opportunity for under-reporting of this income. The under-reporting may be either planned willfully, or in some cases, it may just be the result of poor accounts management.

Either way, it has the potential to lead to tax evasion. Even when there is no tax evasion, the high proportion of cash received or deposited in the banks is enough to attract the attention of the tax-auditors.

Second and the most important reason is that the self-employed are placed at a great advantage to claim their personal expenses as business expenses, and a it is not uncommon for them to make use of this opportunity in lowering their tax liability. For example, a self-employed taxpayer is likely to use his car for both official and personal purposes, but he may claim all the expenses related to the car, like interest paid on car loan, gasoline, repairs & insurance and the depreciation on car as business expenses. Similarly, a self-employed can project his personal pleasure trips as business visits and claim all expenses thereof as deduction. Many self-employed also claim expenses on their home as office expenses, while others claim deduction on account of entertainment and gift expenses as business expenses, even though they may not be actually so. The high probabilities of such practices mean that the self-employed are always a target for audit.

Third, many self-employed maintain their books of accounting themselves, without having the necessary understanding of accounting and law to do a perfect job. As a result, they may end up claiming more deductions than are permitted by the tax code. Sometimes, the self-employed also get involved in abusive tax-evasion schemes prepared by tax consultants or practitioners who misguide them and make them vulnerable to audit.

The selection of audit targets is on the basis of a streamlined risk assessment process that ensures that human discretion is not the primary factor in selecting audit targets. Thus, more are the inputs in their system, which are not easily explained from the taxpayer’s declarations, more would be the probability of a tax audit. Sudden unexplained behavior, assets and income that are not taken into account, or claiming deductions that are clearly impermissible can also trigger the audit process.

Generally, the Revenue agents do their homework and collect the necessary information about the tax-payer they are going to audit. In the process, they match the information available to them from other sources with the information stated by the taxpayer in his return of income. So they have some idea about the life style, the deposits made by the taxpayer and his investments, and when these do not match with the details provided in the return of income, it become a case fit to be audited.

Types of Audit Faced by Self-Employed

The type of audit faced by self-employed depends on the reason behind it. For a single issue that can be easily resolved by providing a particular detail, there may be only a 'correspondence audit' wherein the tax examiner of the IRS Compliance center asks for a particular detail or explanation by mail, and after receiving it from the taxpayer, resolves the issue. In other cases requiring a detailed interaction, the taxpayer is either called to the local area office of the IRS for what is termed an 'office audit', or if the matter is more severe than that, the IRS may conduct a 'field audit' at the business premises of the taxpayer.

The scope of Office audit is limited. Most office audits pertain to annual income of less than $100,000. For higher income groups, or where there are multiple issues selected for verification, the tax auditors, consisting of 'Revenue agents' of the IRS visit the tax-payer at his place of work where they interview the taxpayer and verify the details stated in his return with documents, activities and other material available.

How the Self-Employed Should Prepare

The best that the self-employed can do to prepare for the eventuality of tax audit, can be summarized in five tips:

(i) Be honest while reporting all facts and figures - it saves from a lot of possible problems, headache and costs.

(ii) Have an efficient system of accounting. Preferably hire the services of an accountant.

(iii) Avoid delay in updating of accounts.

(iv) Always make some allowance of personal expenses when claiming deductions for business expenses, and a keep a note for future reference, regarding the reasons followed by you.

(v) Make sure that the deductions claimed are within the law, and the supportive documents to substantiate the amount spent, the genuineness of the expense and its relation with your business or profession is available and properly recorded and preserved.

Targeted by the Tax Administrators

Self-employed are sometimes selected for audit because they indulge in tax-evasion. At other times they land into trouble because they are soft targets and unable to maintain the rigorous accounting details expected by the IRS. However, one must also understand that all that the tax audit looks for is information and evidence for genuine claims and transactions. Once you have ensured that, there is little to be anxious about an audit.