Sole proprietors that choose to be consultants have to face the fact that their industry is subject to a high probability of being audited by the IRS. This is due to the fact of the mixed personal versus business nature of many expenses of both the consultant and family members.
Employee or Independent Contractor
One of the main reasons the IRS audits a high percentage of sole proprietors who are consultants have to do with whether they are an employee or an independent contractor. This is particularly true for displaced workers who have taken on the consulting role and are now engaged by the same company that previously employed them. The IRS also has a perception that consultants are more likely to understate their income and overstate their expenses because they are not subject to the information reporting requirements and tax withholding rules applicable to employees.
The main priority in conducting an audit of a consultant is to verify their gross receipts and confirming that they have all been reported. This generally means that Schedule C will be examined to determine that all income has been reported. One way examiners do this is by attempting to reconcile deposits to bank accounts with income reported. They will also take into consideration non-income sources such as loans, gifts, and interbank transfers.
If the examiner suspects that there is unreported income, they will conduct a more in-depth analysis of the consultant’s deposits or request for substantial additional information to corroborate the reporting of their income. Subsequent years will also be considered for examination if there is a suspicion of unreported income by the examiner.
Financial Status Analysis
Another tactic used by the IRS auditors of individual business returns is a financial status analysis. This analysis will give the IRS the ability to determine whether the taxpayer has sufficient funds to pay known expenses.
The examiner will start with the information on the tax return under audit and internal/external sources of information, and update this information as new information is gathered. This will help the IRS determine whether the taxpayer has sufficient funds to meet current expenses and whether unreported income indicators exist.
Audit Technique Guide
The IRS has an audit technique guide that has a specific section for auditing consultants. This section has recently been updated to include several examination issues that have been prevalent on consultant’s tax returns. These issues include:
1. Travel Expenses – The IRS is generally concerned with family travel and personal travel expenses.
2. Employee Vs. Independent Contractor – The IRS wants to determine whether the consultant is an employee or an independent contractor.
3. Meals and Entertainment
4. Not for profit considerations
These four points will be the main issues the IRS will want to examine on a consultants tax return if they are present. The best way to guard against having to go through a painful IRS audit if you are a consultant is to keep the best records you possibly can. Make sure that everything is documented and kept in a safe and organized fashion.