Why the Self-Employed Are Audit Targets

The IRS keeps a close eye on self-employed individuals. Here's what it looks for.

The IRS claims that most tax cheats are in the ranks of the self-employed, so it is not surprising that the IRS scrutinizes this group closely. As a result, the self-employed are more likely to get audited than regular employees. If you are self-employed, stick to these two rules, at a minimum, to avoid trouble in case you are audited: Claim all of your income, and don't take deductions for items you didn't have to pay for.

If you are self-employed and the IRS chooses to come after you by way of a tax audit -- or, worse, a criminal investigation -- be aware that the agency can obtain your bank records and other financial records. If you've been foolish enough to deposit unreported income in your bank accounts, an IRS auditor may find out.

If you are investigated, expect the IRS to ask the following questions or look into the following issues:

• Did you report all of your business sales and receipts?
• Does your lifestyle appear to exceed the amount of self-employment income you reported?
• Did you report all cash transactions -- especially large cash transactions?
• Did you deduct any personal living expenses as business or home office expenses?
• Did you write off automobile expenses for travel that was not business-related?
• Did you claim large business entertainment expenses?
• Did you make the proper payroll tax deposits?
• Are your workers wrongly classified as independent contractors when they are really employees?

If you have employees, always make the required federal payroll tax deposits when they are due. Never borrow from your employees' tax funds. If you make a late payroll tax payment to the IRS, the penalties and interest can be substantial. If you can't pay, then you probably shouldn't be in business.

One good way to see that payroll taxes get paid on time is to use a bonded payroll tax service to both file your payroll tax returns and make all payroll tax deposits. Many banks, as well as businesses called payroll services companies, offer this at reasonable prices. If they goof up and don't get a form or payment in on time, they will pay the late payment penalty.

As part of a government campaign against the underground economy in general, and drug-related money laundering in particular, the law requires that cash and cash equivalent business transactions over $10,000 be reported to the IRS on Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business. These report forms are also called Currency Transaction Reports, or CTRs. (For a detailed pamphlet explaining this law, see IRS Publication 1544, Reporting Cash Payments of Over $10,000.) Some state tax agencies have similar reporting laws and forms.

If you don't file a Form 8300 when you should, and the IRS finds out, you can be fined, audited, or both. You can also get in trouble criminally -- CTR violations are investigated by the IRS Criminal Investigation Division.

If your business deals in a lot of cash -- for example, you run a bar, a restaurant, vending machines, or a laundromat -- the IRS may suspect you of skimming cash off your receipts. This is true whether you file Form 8300 or not. The audit potential of cash businesses is much higher than average.