Many people believe that the road to paying less in taxes is to be self-employed. Many self-help books encourage developing a side business that can be manipulated to appear to lose money. This is accomplished by taking every allowable deduction for a home office, auto expenses, and percents of utilities and other purchases that serve dual duty for business and personal use. The problem is that the IRS is not a fan of seeing small businesses reporting losses that are only paper losses.
When you report a loss on a business, it is expected to be a real loss. The losses shown from using your home as the office, while allowed, must not appear to be a tax evasion in disguise. Many of these businesses are audited because they are not ever expected to produce a profit. Except for a tax dodge, no one ever starts a business expecting to run it for a loss forever.
Skimming is another problem that is rampant among the self-employed. This is the practice of removing income in the form of cash without reporting it for taxes. Businesses that receive a lot of cash for services rather than inventory can remove large amounts of income easily.
Although an IRS audit cannot always uncover this accounting sleight of hand, it can use formulas for similar businesses to see if the numbers are reasonable.If the IRS determines that a given business is too far away from the average, a more precise audit will be conducted of daily onsite business. Should this reveal a major discrepancy, fines and additional taxes will be the result.
Self-employed people also like to buy personal items through their businesses to reduce their income. Depending on the type of business, these items can be alright to deduct. An architect could easily justify a high priced camera. Most businesses will have no problem with upgraded computer systems. The difficulty comes in when a mechanic tries to slide a big screen high definition television through. These items are deducted from taxable income and often avoid the required sales tax.
Doctors and others who have to travel for training and speaking engagements are allowed to deduct these expenses. However, many try to push the envelope with trips to resorts or cruises that include an hour or two of meetings and a week of fun in the sun. The IRS can require the business owner to prove that the trip fits its rules for an allowable deduction. Taking family members along on these trips at the businesses cost is also a problem.
Another area that causes the IRS to be more aggressive with audits of the self-employed is the self-employment tax. Not only do expenses deducted on Schedule C or some of the other documents reduce taxable income, it also reduces the amount of self-employment tax that is used to drive Social Security and Medicare. At a rate of 15.3% of net income, a few thousand dollars of excess deductions can result in many dollars of lost tax revenue.