Approximately 27 million tax returns are filed every year that include a Schedule C, which encompasses small businesses, freelancing and consulting, gig work, and other types of self-employment. While only about 0.05% of tax returns get selected for audit, Schedule C audits are a common cause as this schedule is simply more prone to errors. Additionally, Schedule C filers tend to take more liberties with deductions, and unlike W-2 income, there is no automatic way to verify the amounts reported.
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How to Pass a Schedule C Audit
1. What is the type of audit?
The field audits typically seen on TV and in movies, where an IRS agent comes to your home, do happen in real life but are relatively rare. You are more likely to receive a correspondence audit, which is conducted by mail. You may also be requested to bring your documents to an IRS office.
In the COVID era, most audits are done by correspondence. You only need to account for the items requested in your notice, not your entire Schedule C or whole tax return. Do not volunteer more information than is necessary.
2. What is being audited?
When you receive your audit notice, the auditor will tell you what they are focusing on under the “Issues to be reviewed during the examination” heading. You do not need to volunteer more information than is requested.
The exact form or item being audited will vary based on your industry, income level, location, and other relevant factors. If the numbers you reported seem inconsistent with prior years, or the industry code you selected for your Schedule C seems to have a major disparity with similar taxpayers in the database, that is likely what triggered the audit if it was not a random selection.
3. When is the deadline for submitting substantiation documents?
Unlike tax returns, there is no uniform deadline for submitting your audit substantiation documents. The IRS will tell you in your notice which documents and records you need to gather and provide with Form 4564, Information Document Request.
The deadline should be printed on your audit notice. If it is not, or you think you need more time, you should contact the IRS immediately to find out when you should submit your documents.
4. Find the raised issues in the audit letter on your tax return(s).
Once you know which items are under examination, you should look over your tax returns and pertinent tax forms and records to prepare your defense.
You may have made a simple math error or accidentally omitted a form and can quickly resolve the issue. Conversely, you may have a more complicated deduction where you’d need to provide substantiation beyond payment records. Knowing exactly what is being audited will lessen your anxiety and help you narrow down which records you need.
5. Compare COGS vs business expenses
A common mistake made with businesses that keep inventory is mistaking cost of goods sold (COGS) and other related inventory expenses with normal business expenses. Having these numbers properly separated can hasten the audit process.
Additionally, you may need other records based on the expenses you’ve claimed. Are they considered typical in your industry? If not, do you have proof that they have commercial substance and are helping you achieve profit? For travel and mileage expenses, do you have logs that line up with your miles and proof that the trips had a bona fide purpose?
6. Get audit representation
Professional audit representation will give you peace of mind that your tax matters are in the right hands. When you seek tax audit defense from Tax Shark, you will benefit from our professionals’ years of tax law and negotiation experience. Additionally, our experts will contact the IRS on your behalf to save you time.
IRS Audit Triggers for Schedule C Audits
There are two chief IRS audit triggers for Schedule C audits, pertaining strictly to income or expenses.
Failure to accurately report income, particularly sales income and cost of goods sold if there is inventory, may trigger an audit. This is especially true of cash income that has not been properly documented, such as with receipts and ledgers.
Business expenses are also likely to be examined if they are not considered ordinary and necessary, such as being too personal in nature. Expenses that lack strong commercial substance are also examined. For example, travel expenses claimed on Schedule C are a frequent target for this reason.
Both income and expenses need to be adequately substantiated. This can be as simple as keeping receipts, but for travel, meals, and entertainment, additional records are often required to prove they are bona fide business expenses.
Facing an Audit with No Receipts?
The more records that you have at your disposal, the better off you will be in the event of an audit. However, audits are not always predictable.
Audits may not always be based strictly on numbers or the types of income and expenses reported on Schedule C. They are sometimes conducted with respect to examining your recordkeeping and degree of business formality. Depending on how the particular IRS branch in question trained the auditor in the systems and procedures outlined in the Internal Revenue Manual, in addition to their level of experience in the field and types of taxpayers they tend to audit, oftentimes the audit content is left up to their interpretation.
Schedule C audits in particular have more nuance and variation to them compared to other types of business tax audits, as many people file Schedule C without having a formalized business entity and the subsequent recordkeeping systems in place that someone with an S or C corporation is more likely to have. The auditor may fairly assess this factor or ultimately hold it against you, depending on the facts and circumstances of your case and how they typically conduct an audit.
Ultimately, the best way to minimize audit risk is to keep excellent records, organize them for easy referencing, and utilize them for meticulous tax return preparation. If you don’t have tax returns filed for previous years, it’s best to file the missing returns as quickly as possible to minimize the impacts of any IRS examinations. If forms were filed incorrectly, such as reporting your self-employment income as a line item on your Form 1040 instead of using Schedule C, amended returns for these years should be filed.
I’m under a Schedule C audit with cash income and no records.
You need to provide as much substantiation for your cash income as possible if you don’t have 1099 forms, credit card slips, or other digital records. Do you have deposit records from the bank showing how much cash you deposited? Receipts from cash register rolls or hand-written receipt books? Try to find as many records as you can.
What are the most common questions asked by the IRS during an audit?
Ultimately, this depends on how your auditor was trained and what items they are examining, if not your entire Schedule C. If the auditor asks you about a specific item, such as travel and entertainment expenses that tend to be audit-prone, they will ask how much these items have to do with your business. If they are unsure whether you have a bona fide business, they will ask about how much you rely on the income produced, your books and records, and other questions about your overall financial situation.
Does the IRS audit all bank accounts under a Schedule C audit?
The examination is limited to relevant accounts, such as your business bank account. If you use the same bank account for both business and personal finances, as is common with many freelancers and gig workers, then this account would also be included if bank records are needed for backup. It’s best to have separate bank accounts for each Schedule C activity whenever possible.
I received a Schedule C audit and don't have a business.
This is common with some types of gig work where no expenses were reported thus Schedule C wasn’t filed, or statutory employees such as certain nurses, truck drivers, and salespeople who receive Form W-2 but claim their expenses on Schedule C and it was omitted. If neither of these situations apply to you, you would need to demonstrate that the IRS made a mistake and you do need to file Schedule C.