Lately, the IRS estimated that $68 billion of the annual $345 “tax gap” was the result of sole proprietorships underreporting income or overstating expenses.  The tax gap is the difference between the amount of taxes actually collected and the amount of taxes the government should have collected.  So the IRS is coming after sole proprietorships to help make up that perceived shortfall.

What are the main issues the IRS will be auditing?

1. Underreported income — Many taxpayers underreport their income simply because they don’t understand the rules.  Bartering and canceled debt are just two types of income that are often unreported.
2. Car & truck expenses — You can deduct actual expenses of using your car for business or take the simpler 55-cents per mile deduction.    The most important point in claiming this deduction is keeping proper records.  You should have a complete log showing each trip, the date, the purpose of the trip, and the number of miles driven.
3. Travel & entertainment expenses — Be sure to be clear between what is personal travel and entertainment and what is truly for business, as this category is a hotbed of audit activity.  If you’re entertaining clients or taking them to dinner, be sure to save the receipt and log it with the names of the clients entertained, the date and the location.  You should be able to articulate the business purpose of the meeting, as well.
4. Gift expenses — If you’re thinking of sending gifts to your clients, remember that there is a $25 dollar per person limit on gift deductions.
5. Hobby businesses – You should be able to prove a profit motive if your business has been showing a loss for several years.  Otherwise, the IRS will claim that your “business” is nothing but a hobby and disallow all the losses!

Don’t let the IRS focus on sole proprietors scare you.  Just prepare yourself,  keep good records and follow their crazy rules!