Sole proprietors: Are you at risk for a tax audit?

What many small business owners do not know is that filing as a sole proprietorship could put you at risk for being audited.

by LegalZoom Staff
updated January 27, 2023 ·  3min read

Now that April 15th has passed, most small business owners feel the collective sigh of relief. They have dug through a year of records, found all the necessary receipts, navigated through all of that paperwork, and even filed on time.

With any business, there are, of course, necessary deductions. Still, a sole proprietorship may raise a few more needless red flags that could be avoided by running your business as a corporation. So what are those pesky red flags, and how does a corporation help avoid them? Here are just a few:

The home office deduction

You may be thinking—yes, yes, we all know about the home office deduction! Unfortunately, most people don't read through how the deduction actually works. Take into account that most sole proprietors work from home, and you can see how trouble can brew.

The home office deduction should only be taken if you use the room exclusively for business purposes. The kitchen nook that doubles as your office space is not exactly what the IRS considers an eligible office.

The space must be clearly used for business purposes. Remember, only a certain percentage can actually be claimed. The other pesky issue is that all of those business deductions then have to be written on a separate form that itemizes home business expenses, sending up a red flag. On the flip side, with an S or C Corporation, you don't have to file a separate deduction form.

Schedule C

Ultimately, the sole proprietorship problem is that no matter what you deduct, the Schedule C form draws attention. In 2006 alone, 4 percent of all sole proprietors filing a Schedule C were randomly audited compared to less than 1 percent of all corporations who filed either Form 1065 or Form 1120S. Why? Well, the IRS is on the lookout for those business owners who hide portions of their earnings because so many people historically attempt to overstate their expenses or downplay their actual cash earnings.

Cash-based businesses

One of the IRS's biggest concerns is the sole proprietor with a cash-based business. Caterers, personal trainers, dog walkers, this means you. Many self-employed professionals tend to receive large amounts of cash that go undeclared. And unfortunately, the IRS is all too aware of that.

Understating earnings

Another common mistake is "understating" your earnings by "overstating" your deductions and expenses on your Schedule C. And, well, there is a difference between deducting a few business meals a month and deducting your weekends out with your spouse for the entire year. Again, entertaining business clients or paying for business meals may be part of your job, but only a certain portion can be deducted and only under certain conditions.

The other thing you want to avoid is taking too much of a deduction on your automobile expenses. You can deduct the cost of your car if you use it for business purposes. That means you can either deduct the mileage at the rate of 44.5 cents per mile in 2006, or you can deduct the ordinary expenses you incur, such as gas, oil changes, and parking fees. But, when you also start to deduct the cost of gas on your family road trips to the Grand Canyon or Yellowstone National Park, you may raise a few eyebrows.

Other no-no's

There are a few other areas where a sole proprietor can get themselves into a bit of trouble. One of the biggest no-nos is mingling business and personal expenses and monies in the same bank account. It makes the business look like a hobby more than a business, making bookkeeping infinitely more difficult.

Oh, and estimates might get you into a bit of heat as well. You will rarely get your meals or other deductions to equal a perfectly round number, so jotting them down on a Schedule C that way can easily send up a red flag.

The benefits of a corporation

With a Corporation, your expenses are entirely separate from the business's expenses. You will likely have a separate credit card and banking accounts where you can track business meals, gas for business, and other issues. The IRS forms are also consolidated and filed separately from your personal expenses because the business is a separate legal entity.

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