The IRS examined just over 1 percent of all individual tax returns for the 2011 tax year, but the self-employed are more likely to be asked to document their returns, says Jackie Perlman, principal tax analyst at the Tax Institute, the research and analysis division of tax prep company H&R Block (HRB). There’s good reason for that. Unlike wage earners who receive W-2s from their employers, the self-employed, especially those in cash businesses, are essentially on the honor system when it comes to reporting income.
But the fear of being audited shouldn’t keep the self-employed from taking deductions, Perlman told me recently. We discussed how to prepare for a possible audit and what to do when the dreaded letter from the IRS comes. Edited excerpts follow.
How the self-employed can avoid being audited is probably the wrong question. What should you do to prepare for the possibility of being audited?
You avoid an audit by not taking any deductions, and that’s not a good idea. If you have legal expenses, claim them. You’re supposed to, and you’re entitled. It comes down to how you manage your business. Keep good records. Keep invoices. It’s a very good idea to keep separate checking [accounts] and credit cards for your professional and personal purposes. It’s easier if you don’t have a single credit-card bill with your office supplies and kids’ toys and baseball tickets on it.
Are there common pitfalls that taxpayers should be aware of?
There are a lot of rules around when you can deduct business mileage. You need a contemporaneous log, which means you’re doing it while it happens. You can use MapQuest or Google Maps, or whatever to document what the mileage is. The idea is that each day isn’t a carbon copy of the day before. Put on your auditor’s hat. If I were auditing this, would it look like a real log, or would it look like [you were] just copying the same things over and over?
What if you weren’t keeping a log, and now you want to play catch up on your record-keeping?
It’s difficult. You can recreate as best you can. Maybe you have your appointments in your calendar, but it’s less persuasive. If you have good client records, and you can show you invoiced these folks, you might be able to do that. Very generally, when people are denied, it’s because they keep poor records and their claims are not believable. If you can’t do it for [tax year] 2012, start doing it for [tax year] 2013.
What are some other sticky areas?
The home-office deduction is one. Another main point of contention is not separating business from personal. If you go to Office Depot (ODP) and you buy copy paper and so on, and then you pick up some other things, a video game for your kids. You want to be very careful about that. If you get paid in cash, you should be recording that as it comes in. Basically anything that you deduct, you should have receipts backing it up.
What happens when you get an audit letter from the IRS?
Don’t ignore it. It’s not going to go away. It may sound silly, but a lot of people are like, I don’t want to open it. If it’s a simple correspondence audit, send what is asked, send by the date it’s asked for, and don’t send anything else. Don’t answer a question that’s not asked of you. If it’s a face-to-face audit, I would recommend getting representation. It’s worth it. Some people who represent you will ask that you don’t go along. You hear of cases where the IRS says, “That’s not deductible,” and the client says, “What do you mean? I’ve been deducting it for years.”
What if you cheated on your taxes, and now you’ve been caught?
Get representation. You tell them what you do have substantiation for and what you don’t, and put it in their hands.
For more advice, the National Association for the Self-Employed has been holding a series of webinars on audit-proofing your tax returns.