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Sole Proprietors are Three Times More Likely to be Audited by the IRS

Schedule C is the tax form that unincorporated sole proprietor businesses use to report their income and expenses as part of their individual income tax returns. Schedule C's have been center stage in recent IRS “tax gap” estimates.

The tax gap is defined as the amount of tax liability faced by taxpayers that is not paid on time. Last year the IRS released new tax gap figures.    The IRS estimates the tax gap has increased to $450 billion. Of that $450 billion, approximately $372 billion is attributed to underreporting in the following categories:

Schedule C underreporting 193
Underreported Income - not from business 73
Overstated deductions, exemptions & credits 42
Payroll taxes 20
Corporate income tax 39
Estate tax 5

Since Schedule C underreporting represents the largest category, and over half of the underreporting, it is no wonder that the audit rate for Schedule C returns has increased substantially and is among the highest of the rates. Based on 2010 IRS figures, Schedule C's have a 300% higher chance of being audited than either an LLC, partnership or an S Corporation. Of the Schedule C's audited in 2010, the average adjustment exceeded $9,000.

Among the areas of underreporting are:

  • Personal Expenses – Over-deductions attributable to the inclusion of non-deductible personal expenses and the failure to allocate for personal use of a vehicle.
  • Underreporting Income – Failure to include all income. To counter this problem, the IRS has initiated merchant card and third-party reporting that will provide the IRS with all income from credit card sales.
  • Worker Misclassification - Misclassifying workers as independent contractors instead of treating them as W-2 employees, and thereby avoiding the employer’s share of payroll, unemployment, and other taxes. The IRS currently has a Voluntary Classification Settlement Program in effect that allows eligible taxpayers to voluntarily reclassify their workers for federal employment tax purposes. Voluntary programs usually precede more aggressive compliance measures.
  • Failing to Issue Information Returns – Generally, businesses are required to issue 1099s for fees they pay to individuals other than employees or to corporations. This is a huge area of non-compliance and denies the IRS the ability to ensure the payees are properly reporting their income. In an audit where a 1099 should have been issued and was not, the IRS will generally disallow the deduction for those services. The 2011 Schedule C asks two catch-22 questions: “Did you make payments that would require you to file a Form 1099?” followed by “If yes, did you or will you file all required Forms 1099?”
  • Hobby Losses – Some businesses are actually hobbies where there is no real intention of ever making a profit. Businesses deemed to be hobbies have special rules that limit the expense deductions to the income and require the deductions to be taken as an itemized deduction on Schedule A. Watch for a future article on hobby losses that will appear in the March newsletter.


If you have questions related to your business or personal tax return, we are here to help.

The content of this transmission does not constitute a professional service nor does it constitute a tax opinion under IRS Circular 230. Always consult with a competent professional service provider for advice on tax, accounting, and other financial matters specific to your situation. If you wish to engage our firm for this purpose, please contact our office.

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