IRS to Audit Sole Proprietors More Carefully

A report released by the Treasury Inspector General for Tax Administration (TIGTA), the government agency responsible for providing independent oversight of the IRS, recommended steps the IRS could take in order to better detect unreported income while performing audits of sole proprietors.

IRS auditors already do a number of checks to look for unreported income, such as examining the “cost” of the sole proprietor’s lifestyle to see if his/her reported income would be able to support it.  If you’re driving a brand-new BMW but reporting $20,000 in net business profit as your sole source of income, you should expect a lot of tough questions!

The new test being recommended includes a more sophisticated analysis of tax return data and the proprietor’s reported personal expenses to determine if they are roughly equal.

If you operate your business as a sole proprietorship, your best defense against an audit is thorough documentation of both your gross revenue and your business deductions.  The following post can assist you.

Should You Give IRS Your QuickBooks?

Did you know that the IRS could now require you to produce your QuickBooks company file if your business is being audited?  This started happening in late 2010 and the practice is only going to grow. How to protect yourself in the event of an audit?

  • Review your own books.  It only makes sense to go through your own books first and see if there are any red flags.  Comb through all Checks and Credit Card charges to look for all personal expenses.  Sometimes business owners grab the wrong card out of their purse or wallet.  Better for you to go ahead and re-categorize these transactions as “Owner’s Draw” or “Advance to Shareholder” now, rather than waiting for an auditor to find them.
  • Back up your QB file at the end of each year so that each year is in its own QB Backup file.  Previous years should be “condensed” first so that the only data the auditor can see is the year under audit.  This prevents any “fishing expeditions” by your friendly IRS auditor.

From Forbes.com – 6/03/2011

“No, not usually.  In fact, you might think it’s silly to contemplate it.  Why make it easy for the IRS to mine your own data?  But the IRS is increasingly asking and it’s unclear how the fisticuffs will end up.  See Small Businesses Fight IRS Over Data.

You want to cooperate, but you don’t want to turn over data hurting your business or provoking audits of other areas the IRS isn’t considering.  If you express concern to the IRS that your off-the-shelf software has lots in it you aren’t comfortable disclosing, the IRS can choose to issue a summons.  That could mean you can fight about it in court.

The IRS told the American Institute of CPAs (AICPA) it needs electronic business records.  Could this mean customer lists, personnel data and more?  How the IRS will use it is troubling, especially if you’re not sure what you have embedded in your software.

There’s nothing new about the IRS wanting electronic data, but usually such inquiries involve big businesses.  Small businesses are defined as those with assets less than $10 million, and they often use off-the-shelf software such as QuickBooks.  In contrast, big businesses usually have customized accounting systems that facilitate providing the IRS only with what they want.

In a letter to the IRS, AICPA proposed allowing companies to redact software to release only relevant data.  Although there’s some informal precedent, the IRS rejected the request.  The IRS suggests that small businesses should back-up at year end, limiting IRS access to one year at a time.  The IRS also said it would allow businesses to reduce the detail for years not under audit.

Yet fears remain.  Unless the IRS relents, small business owners may decline to provide it–and see if the IRS issues a summons–or simply turn it over and hope for the best.”

By Robert W. Wood, Contributor

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