When people think of the IRS, there is one word that people dread above all others: audit. Being audited by the IRS is analogous to getting a root canal from your dentist, in that it’s the worst thing that can happen with that person or service. Many different kinds of people can be audited, but one of the biggest targets for an audit are the self-employed.
When self-employed people file their federal taxes, they have to fill out a form called Schedule C. Schedule C is a guide to all of the income that the business has received, and all of the expenses that they have paid. With regards to an audit, both income and expenses can get you into trouble.
Income can sometimes be simple and easy to report, but other times it can be difficult to report and substantiate without documentation. For independent contractors who work for only a handful of clients, income is generally easy. At the end of the year the contractor should receive a 1099-MISC from each client that he or she worked for. This form states the income clearly and simply, and everything should be fine as long as the income stated on the return matches the copies of the 1099-MISC that the IRS received. However, for taxpayers who run businesses with many customers, such as shops, garages, cleaners, restaurants, etc., there are no 1099s to show the income. In these cases, it is up to the taxpayer to keep track of the income that they receive from their business.
Expenses are almost always difficult to keep track of, substantiate, and report for the self-employed. Sometimes taxpayers don’t keep proper records of their business expenses, then do an estimation or guess when preparing the return. Doing the taxes this way greatly increases the risk of triggering an audit. However, it’s easy to understand how some taxpayers miss some of their record-keeping duties: even if a taxpayer saves every receipt from every purchase they’ve made throughout the entire year, it still may not guarantee them the ability to correctly prepare their taxes.
One of the most important aspects of correctly accounting for your own business is to separate your personal expenses from your business expenses. This can be more difficult for some kinds of business than others, but some amount of overlap between personal and business expenses will exist for almost every self-employed taxpayer. For instance, some of the expenses that a self-employed person can claim on Schedule C are business mileage, business use of the taxpayer’s home, and travel, meals, and entertainment.
The problems that can arise from trying to track some of these expenses are somewhat obvious. For example, a taxpayer may use their own personal vehicle for the business. Even if a taxpayer keeps track of their total mileage for the year, car trips for personal matters are obviously not deductible as a business expense. Similarly a taxpayer can keep track of every meal out that they’ve had throughout the year, but not all of these meals will be qualified as legitimate expenses for the business. The only real solution is diligence and discipline.
If you are self-employed, one of your basic responsibilities is to keep current with your record keeping. If you drive for business purposes, keep a separate mileage log than what you might use for your personal trips. If you have a business meal out, keep the receipt separate from your personal meals. The most important thing is to keep records as you go, and to hold on to those records for as long as you need. The length of time that you need to hold onto those records varies, but the general rule of thumb is told onto all of annual tax records for at least three years after that year’s return is submitted, audited, or amended. If a return is audited or amended, then the three years start over.
Owning and operating your own business is difficult. Keeping perfect records to appease the IRS makes it even more difficult. However, these difficulties should be recognized and factored into a decision to open a business before the business is opened. If recording your expenses and keeping track of income is overwhelming, then you probably shouldn’t open your own business. However, if you possess the determined spirit to overcome any obstacles in your pursuit of opportunity, then taking the trouble to do your accounting correctly is well worth the chance to fulfill your dreams of owning your own business.