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!

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.