According to a recent report by the IRS, auditors are going to be stepping up their audits of sole proprietors, looking for unreported income and unfiled tax returns.

In addition to searching for unreported income, the IRS will be looking for sole proprietors who did not file required employment tax returns or information returns.

How to prepare your business in case the IRS comes knocking?  It all comes down to preparation and documentation:

• Improve your recordkeeping. Be prepared to back up every number on your tax return with complete documentation on the details and purpose of each expense.  If you do this with every expense at the time of purchase, you won’t be leaving yourself with hours of catch-up work at tax time.  Even worse, an audit that occurs in the fall of 2010 could be for expenses incurred in early 2008!
• Consider professional help. Even if you feel confident in preparing your own tax return, it’s worth your time and money to have a professional review your return every couple years.  Not only may they catch mistakes, but they may catch missed deductions or new tax-saving opportunities.  Two sets of eyes are always better than one!
• Don’t stick your head in the sand. If you hate bookkeeping so much that you just never get around to it, then consider hiring some outside help.  What might take you several late nights of agonizing stress might only take a couple of hours for a professional bookkeeper.  I help several sole proprietors and small business owners with ALL of their bookkeeping needs with only five to ten hours per month.  The bookkeeping gets done (properly!) and the business owner has an extra ten hours to spend on billable hours, business development, or whatever else is at the top of their priority list!

The IRS just published their IRS Enforcement and Service Results for their fiscal year 2009.  Based upon this new data, the higher your income, the more likely that you’ll receive a letter from the IRS asking for additional information or tax payments.  A correspondence audit of this kind is often triggered when you forget to report all of your 1099 payments, including “freelance” payments that were reported to you on a 1099-MISC.

The statistics released by the IRS show:

• Individuals with income over $200,000 had an audit rate of 2.89%
• Individuals with income under $200,000 had an audit rate of 0.96%

For businesses the results were:

• S-Corporations had an audit risk of 0.40%
• Partnerships had an audit risk of 0.38%
• Sole Proprietorships were not broken out from individual results

For upcoming audits, the IRS has already announced that Sub-S Corporations that are not paying shareholder/employees “reasonable compensation” will be at the top of their audit lists.

According to a new report by the Government Accountability Office, about 25% of all sole proprietors reported losses in 2006.  Most of these business owners used their self-employment loss to offset other taxable income, leading to a significant loss of tax revenue for Uncle Sam.

According to the IRS, approximately 70 percent of those losses were at least partially a result of taxpayers incorrectly applying the tax laws.  So how is the IRS going to go after these missing taxes?  Two suggested approaches are:

• The IRS could limit the amount that sole proprietor losses could be used to offset other taxable income.  While the IRS is concerned that this move could limit the ability to claim legitimate losses, it would certainly limit bogus losses.
• The IRS could go after “hobby” businesses, or those business that are not engaged in for profit.  Basically, these businesses have to claim the net sales revenue generated, but are not allowed to claim expenses except as itemized deductions.  The IRS seems to be leaning heavily toward this option.

Is your business really a hobby?  According to the IRS, if you haven’t made a profit in three of the last five years, then it very well may be!  You should be prepared to prove that you’re trying to make a profit and have a legitimate business, not just a money-making hobby.

So, are scanned versions of your receipts and business records acceptable to the IRS?

In 1997, the IRS started accepting digitized or scanned versions of paper documents in lieu of paper documents.  In order to be adequate for audit purposes, the business must ensure an “accurate and complete transfer of original computerized books and records to an electronic storage media.  The electronic storage system must also index, store, preserve, retrieve, and reproduce the electronically stored books and records.” (see IRS Rev. Proc. 97-22)

So, from a practical perspective, what does this mean?

• Save your documents … and make multiple backups.
• Make sure that any given document can be found easily, with a helpful file name and a logical folder hierarchy.  An index should be established, as well.
• The storage format needs to be indefinitely acceptable.  If you save your documents in Adobe PDF format, you’ll be reasonably sure that the file can still be opened five years from now.  If you save your files in another format, can you say the same thing?