If you’ve been an independent consultant for long, you already know many of the pros and cons of working for yourself. However, here is one unhappy fact you may have missed: Independent consultants face a much greater chance of being audited by the Internal Revenue Service than their salaried counterparts.
Tax returns are flagged for IRS audits for a number of reasons. They can be pegged at random, set apart by discrepancies in the numbers (your clients report $82,345 in gross income but you report only $50,000), or they can contain certain warning signals. Although the IRS doesn’t disclose exactly what signals send up the red flag, here are a few ways to lower your chances of being audited.
Don’t use round numbers
An easily avoidable pitfall is the practice of rounding your numbers. If you spent $23.75 at the office supply store, record that amount, not $23 and not $24. You will arouse suspicion if you report that you spent exactly $3,000 for office equipment and drove precisely 1,000 business miles in your car.
Keep your deductions in line with your industry
The IRS rule of thumb allows you to deduct the cost of items commonly used by others in your profession—“reasonable" and "customary” are the keywords. For example, it’s reasonable for consultants to deduct cell-phone service—your clients need to be able to reach you, and you wouldn’t otherwise have a fixed office number. If you have your own office, necessities from a stapler to a desk are also common. However, a second cell phone for your teenager is clearly not deductible, and a new stereo system for your office is questionable.
A single inexpensive, questionable deduction may go unnoticed, especially if it can be listed as part of a broader category such as “office supplies.” A single expensive deduction or a collection of smaller items will be more conspicuous.
Deductions that exceed your business income, even in a start-up year, will also spark suspicion. Of course, if you’re losing money, you’ll want to take every possible deduction you can. Just be conservative with your deductions, especially if you can’t avoid some of the other red flags.
Avoid sudden decreases in income
Of course you don’t want to lose money. Unfortunately, a contractor’s income is more likely than not to fluctuate wildly. If you lose a big client or just decide you’ve had enough and want to take some time off, be aware that reporting a loss or a precipitous drop in income will grab the IRS’s attention.
If you report $125,000 in income one year and $42,000 the next, the IRS might come looking for the missing money. If you report a loss, the IRS may suspect that your business is a front for a hobby or other nonbusiness activity.
Although you can’t pull money out of a hat, you can at least do the following when you know your income is going to drop:
- Try to avoid taking large deductions or shift them to a year of higher income. For example, if you know by April 15 that you won’t make as much this year as last, you could decrease last year’s net income by making a much larger retirement contribution than you had planned—perhaps even the maximum amount allowable. In effect, make both this year and last year’s contribution now, decreasing last year’s net and increasing this year’s. Similarly, postponing large equipment purchases can help.
- Know that you may be headed for trouble and be very vigilant about your deductions and record-keeping.
Have you been audited?
Has the IRS ever singled you out? Did you escape the audit unscathed? What saved you? Post a comment below or send us a note.
Reconcile your 1099s with actual income
Don’t allow obvious mistakes to happen. Any client who paid you more than $400 in one year must report those payments by filing a 1099-MISC form with the IRS. When you receive your copy of the 1099 from each client, add up your check stubs or invoices for that client and reconcile that total with the sum on the 1099. Accounting departments can make mistakes.
If you do find a mistake, make sure the client corrects it. A client’s accounting department made a mistake on my 1099 by counting one of the payments twice. After I pointed this out, the accountant issued a corrected 1099 but neglected to mark the “corrected” box to let everyone know it was a corrected version and not an additional 1099.
So, instead of one extra paycheck reported to the IRS, the IRS now has an extra year of income reported from this client. I was too afraid to ask for yet another 1099, so instead I had the accounting department write a letter noting their mistake. It’s in my files, awaiting that potential IRS review.
Double- and triple-check your returns
If you prepare your returns yourself, don’t wait until the last minute—do it early and then hold the return for a week or more while you look over it and check every detail. Are any lines blank that shouldn’t be? Are there numbers that should agree that don’t? Is it legible? For neatness as much as accuracy, you may want to use commercial tax-preparation software.
Or you may want to hire an accountant or a tax service to prepare your return. Some people say the IRS is less likely to suspect a professional of fudging the numbers on your return. But to be on the safe side, I used a professional tax-preparation service the year I received the extra 1099 because of the thousands of dollars of unreported “extra” income.
The secret to surviving an audit is paperwork
While prevention is your first line of defense, you should always be prepared for an audit. To that end, the most important thing you can do to increase your chances of surviving an IRS audit with minimal damage is to keep excellent records. The IRS is not going to take your word for anything, and the more documentation you have, the better your chances of survival.
Implement a filing system that is separated by year and is consistent from year to year. Then maintain it, preferably with some sort of online tracking system—even a simple spreadsheet is invaluable when preparing your return. Sorting through piles of receipts and invoices on April 13 is not only frustrating, but the last-minute rush is also likely to produce errors.
Reconcile your paperwork with your online system before you use it to prepare your return and be sure to refile and reorganize everything when you finish. Here are a few of the things you must be sure to maintain:
- Receipts—If you don’t have a receipt, don’t claim the deduction. If you can’t find a receipt, try to obtain a copy from the company who sold you the item. Credit card statements are dubious proof because many don’t itemize what you bought.
- Bills—Like credit card statements, canceled checks don’t prove anything except that you paid for something. If you pay a business-related bill by check, the important item to file is the invoice, along with the canceled check if possible.
- Mileage logbook—If you use your automobile for business, track all your business mileage. Keep a logbook in your car and use it at the beginning and end of every client visit and office-supply run. Record the date, starting and ending mileage, and the client name or other business purpose. If you can’t be bothered with a logbook, buy a small voice recorder and record the information as you get in and out of the car.
- Appointment book—Don’t toss your appointment book at the end of the year. Keep it as a record of your business meetings, the conferences you attended, and the business-related errands you ran. It corroborates your receipts and mileage and, in the event of a loss, helps attest that your business is legitimate and real.
- Check stubs and invoices—Keep a copy of every invoice you send a client and the check stub that goes with that invoice.
- Account statements—If possible, use separate bank accounts for your business. File all account statements, both business and personal.
If you are audited and found to owe back taxes, you can appeal that audit by writing your district director to report that you disagree with the amount you owe. You may be able to reduce the amount you owe but be aware that if you lose, you’ll owe late fees, too.
Meredith Little runs InfoDoc Solutions, a documentation consulting business she started in 1998. Based in Colorado, the company provides procedural documentation, knowledge management expertise, and solutions such as user manuals and online help to IT companies nationwide.