Key Takeaways:
- Schedule C is submitted by self-employed individuals, sole proprietors, gig workers, and others
- A Schedule C audit may happen if the IRS suspects you didn’t report all your income, claimed deductions you’re not eligible for, or reported other inaccuracies on your tax return
- Eight ways to pass a Schedule C audit:
- Keep organized records
- Understand the type of audit
- Gather your records
- Provide all information requested
- Be cooperative and professional
- Respond right away
- Work with a tax professional
- Never try to hide anything
- Avoid common pitfalls of Schedule C audits like failing to track your expenses, not separating personal and business expenses, or claiming ineligible deductions or credits
Taxpayers are required to file a tax return each year that only includes accurate and transparent information about income and expenses. There is a chance the IRS will audit the taxpayer or business anytime a return is filed.
This chance remains low, but it’s been found to increase for complex business tax returns with Schedules C or F with income of over $200,000 but less than $1 million. The Transactional Records Access Clearinghouse at Syracuse University reported that audits for this group occurred at a rate of 0.19% in 2022. The odds of an audit in 2022 overall were 3.8 out of every 1,000 returns filed, or 0.38%. The largest group of taxpayers who were audited were low-income wage earners who took the earned income tax credit.
Some taxpayers may be subject to a Schedule C audit, yet they are unsure what this process entails or how to handle it. This guide provides an overview of the audit process and tips for passing a Schedule C audit.
What Is Schedule C?
Schedule C is a form used to report business income and expenses for the year. Sole proprietors, freelancers, gig workers, self-employed individuals, and others use Schedule C. The purpose of Schedule C is to provide an accurate accounting of a business’s income and expenses in order to correctly calculate any taxes owed.
Completing Schedule C requires some basic information about your business, such as the name, address, and type of activity it conducts. You’ll also need to provide details about your productive activities over the course of the year–like how much you earned from sales or services provided–as well as any related costs, such as materials or supplies purchased for the business.
Once all of this information is filled out on Schedule C, you will be able to calculate your total business profits or losses on Line 31 of the form. Then you will enter this figure onto Form 1040 when filing taxes with the IRS.
What Is a Schedule C Audit?
A Schedule C audit is an IRS process for determining if the information reported on a taxpayer’s tax return is accurate. An audit may be triggered when the IRS finds discrepancies in a taxpayer’s self-employed income and expenses. The IRS may be looking to ensure proper reporting and payment of taxes, or it may suspect fraud or other illegal activities.
Schedule C audits are common since this type of reporting is more likely to see mistakes. Compare W-2 income, which is reported by the employer and is consistent, versus self-employment income, which can be reduced by deductions that are harder to track and verify.
The IRS will review business income and expenses listed in the taxpayer’s Schedule C form, as well as any supporting documentation. The IRS may also review other aspects of the taxpayer’s finances depending on the scope of the audit.
The audit process often involves a thorough review of past tax returns, bank records, accounting reports, invoices, and other financial documents to ensure accuracy and compliance with IRS regulations. Depending on the extent of the audit and the size of the business, these audits may take months or even years. Taxpayers are required to present evidence supporting declarations made in their previous tax filings or provide explanations for any discrepancies found. The auditor may also request additional documentation or interviews with taxpayers or third parties involved in any irregularities as part of the audit process.
The audit will come to an end at some point. Taxpayers will receive either a notice accepting their filings or an assessment of additional taxes due if errors are found.
Have You Been Audited? Get Expert Help From a Tax Attorney.
Factors That May Trigger a Schedule C Audit
The questions asked during a Schedule C audit will depend on what is being audited and the individual’s unique situation. The IRS commonly looks at the following components of your tax return and asks questions accordingly:
Reported Income
One of the most common triggers for Schedule C audits is when the IRS suspects you failed to report all income from self-employment. The agency may learn of a discrepancy based on what you reported and what it received from a third party, like a client or employer.
Claimed Deductions
Another red flag for auditors is when you claim incorrect deductions on your tax return. A common example is deducting personal expenses as business expenses.
Reported Capital Gains
You may receive capital gains when you sell business property. The IRS may audit you if you fail to report this capital gain, as it is likely subject to the capital gains tax.
Standard Mileage Deduction
Many businesses may qualify for the mileage deduction for travel costs. The IRS pays attention to whether what’s reported on Schedule C exceeds the standard mileage deduction.
Reported Business Losses
The IRS monitors what’s reported as a business loss. They may audit you if it suspects you have overstated business losses beyond what is reasonable.
Significant Inconsistencies
You may be audited if what you reported on Schedule C seems outrageously inconsistent with your past tax years or it seems unreasonable when compared to similar taxpayers in your situation.
Payment Type and Industry
Businesses that receive large cash payments or operate in risk industries may also face increased scrutiny from the IRS.
IRS auditors will ask questions about what payments you received for services, how payments were processed, the records you kept to document business expenses, and whether you documented everything accurately. You will be required to provide any and all information they request, as well as explanations in some cases.
Eight Tips for Passing a Schedule C Audit
Facing the prospect of an IRS audit can be intimidating and stressful. By following a few simple steps, however, you can make sure the process goes as smoothly as possible. These eight tips can help you pass a Schedule C audit:
1. Keep Diligent, Organized Records
You can often breeze through an IRS audit if you have excellent records. Try to organize everything by type of document and store them somewhere secure. Keep all receipts for business expenses. Track invoices and tax forms. Keep your past tax records for at least three years.
2. Understand the Type of Audit
There are different types of audits and different formats for how the IRS conducts them. It is rare for an IRS agent to visit your home or business, which are known as field audits. Much more common are correspondence audits. This is when you just need to provide information to the IRS through the mail. You’ll receive a notice about the audit and a deadline to provide everything for the audit.
3. Gather Your Records
Find and gather all relevant documents. It is important to provide any requested documents in full and on time. If there are discrepancies between the information provided by different documents, be prepared to explain them in detail. Make sure all documentation provided is legible and organized neatly so auditors can easily review it. Unreadable documents could cause delays in processing, which could negatively impact your audit results.
4. Provide All Information Requested
Thoroughly read the audit notice so you know exactly what you’re being asked. Provide everything the IRS requests, but not more than what they need. There is no need to volunteer additional documentation they didn’t ask for.
5. Be Cooperative and Professional
Remember to remain professional and calm throughout the process. The auditor is simply doing their job and is not there to judge or criticize you. Be polite and cooperative while answering questions honestly and accurately. This can help the process move quickly and efficiently. Show the auditor that you want to work together to get everything resolved.
6. Respond Right Away
It’s important to respond promptly to requests from the auditor. Ignoring them can prolong the audit unnecessarily and result in additional fines or penalties if any discrepancies or errors are found on your return. Be sure to provide responses in a timely manner so as not to slow down the audit process more than necessary. Your audit notice will provide your deadline for submitting your documents.
7. Work With a Tax Professional
Have an accountant or tax attorney present during your audit, if possible. They can answer tough questions, advise you if anything unexpected comes up during questioning, or guide you if there are specific documents requested that weren’t previously discussed during preparations for your appointment with the auditor.
8. Never Try to Hide Anything
Be honest and forthcoming throughout the process. It’s not worth trying to hide something from the auditor–they can usually uncover false information or missing documentation quickly, and it may result in further penalties or investigations being brought against you by the IRS.
Consider possible topics the auditor might ask about when you’re preparing for an audit, such as recent purchases, salary payments, and sources of revenue. Talk to your accountant or other tax professional about the information you provided in your tax return.
Have You Been Audited? Get Expert Help From a Tax Attorney.
Common Pitfalls of Schedule C Audits
Many mistakes either lead to a Schedule C audit or cause the process to be much longer than necessary. It’s also worth noting that certain errors and oversights can lead to further problems with the IRS, like penalties and even tax fraud charges. Here are some common pitfalls to watch for:
- Failing to carefully track deductible business expenses. Keep accurate records of all business expenses you can deduct from your income.
- Claiming ineligible deductions or not taking advantage of appropriate credits and deductions. A tax professional can help you understand which deductions and credits you’re eligible for.
- Incorrectly classifying workers as independent contractors instead of employees. Employers need to understand the difference between a regular employee (who receives a W-2) and a contractor (who receives a 1099).
- Paying yourself as a W-2 employee when you file Schedule C as a business owner. Owners can’t use Schedule C to pay themselves as W-2 employees. An owner would instead need to convert their business to a corporation. (Keep in mind that a limited liability company is not a corporation.)
- Not separating personal and business expenses properly. This is one of the most common mistakes on Schedule C. Make sure you don’t include any expense that was not applicable to the business.
- Not being able to prove income and expenses with receipts or other documentation. You never want to be in a situation where you can’t substantiate your claims.
- Leaving out important information or including incorrect data on your Schedule C. Both of these situations can be due to a lack of understanding of tax law, regulations, or rules changes from year to year.
- Overstating your expenses or underreporting profits. Some people do this to reduce their taxable income, but this is illegal and never a good choice.
Make sure you are diligent in everything you do relating to your taxes. Staying in good standing with the IRS means avoiding paying penalties, fees, and associated interest on top of the tax you already owe.
Contact a Tax Attorney for Audit Assistance
IRS tax audits are stressful, but they can be more manageable if you prepare thoroughly and provide honest answers throughout the auditors’ process. Keeping accurate records, providing all requested documents on time, staying organized, having representation present when possible, and remaining honest throughout will help anyone facing a Schedule C audit.
The team at Silver Tax Group is here to assist you through a Schedule C audit or other tax issue. Reach out to Silver Tax Group to speak to an expert about tax audits.
Schedule C Audit Frequently Asked Questions
A Schedule C audit is a type of IRS audit that focuses specifically on businesses operating as sole proprietors.
Schedule C can be audited by the IRS if you report income or losses from a business you own or operate as a sole proprietor. This audit can be triggered by high expenses compared to income, operating in a cash-heavy industry, not reporting all income, large deductions for travel, meals and entertainment, and significant changes in expenses or income from year to year. Respond promptly to any requests from the IRS.
The most common triggers for a Schedule C audit are high expenses compared to income, operating in a cash-heavy industry, not reporting all income, large deductions for travel, meals and entertainment, and significant changes in expenses or income from year to year.
A Schedule C loss may prompt an IRS audit. Even if your business has reported losses for multiple years, a net loss on your Schedule C doesn’t imply wrongdoing. However, the IRS may still choose to audit your return. The goal of the audit is to verify that all deductions are valid and that you aren’t using business losses to offset personal taxable income. To avoid audit triggers, keep precise records and consult a tax professional.
You can report losses on Schedule C indefinitely if your business aims to make a profit. However, if you consistently report losses without signs of future profitability, the IRS may investigate and reclassify your business as a hobby. Keep accurate records and consult a tax professional to comply with IRS regulations.
To prepare for a Schedule C audit, you should gather all necessary documentation, review your return for accuracy, and consult with a tax professional if necessary.
If you’re being audited, it’s important to respond promptly and accurately to any requests from the IRS. You should handle the initial contact, work with the auditor throughout the process, and consider disputing any findings you disagree with.
To pass a Schedule C audit, you should keep good records, be honest and transparent with the auditor, and address any issues that arise during the audit in a timely and professional manner.
