While there's no magic formula to determine what can trigger an audit and what doesn't, there are some patterns that seem to be pervasive. One pattern that causes alarm among small business owners is the frequency of audits of taxpayers who file a Schedule C. So, does filing a Schedule C make you an audit target? Well, yes and no.Statistically, taxpayers who file a Schedule C are two to four times more likely to be audited. This may, however, have to do with the nature of what's on your Schedule C than the actual schedule.
For example, high-income taxpayers tend to be audited more often than low-income taxpayers. Many tax professionals recommend that taxpayers who are collecting substantial income from a small business consider incorporating in order to avoid filing a Schedule C, which attracts attention.
Additionally, taxpayers who file a Schedule C have more issues with record-keeping. By its nature, the schedule is an information-heavy schedule -- there are items of income and deductions. This opens the door for more mistakes and potential abuse, especially when it comes to generating losses. The IRS estimates that as many of 70% of taxpayers who report net losses on a Schedule C have artificially inflated expenses to create losses. If you're reporting losses on your Schedule C every year (especially for three or more years in a row), you might catch the attention of the IRS.
Many taxpayers who file a Schedule C may receive income from multiple sources. This increases the chances that you might omit income on a form 1099 or otherwise make a reporting error. Considering the IRS tends to crosscheck your information forms (like forms 1099 and W-2), forgetting to report income can cause the IRS to carefully examine the rest of your return.
To keep your chances of audit low when filing a Schedule C, keep good records and properly report your income and deductions. Be scrupulous and meticulous -- don't ballpark income and deductions. Round numbers may signal that you're taking guesses rather than reporting accurately.
Some tax professionals also recommend incorporation in order to keep your business records completely separate from your personal records. This may also offer you other benefits, including reducing your liability. If either of these issues are a concern, consult with an attorney to find out if it makes sense for you.
That said, don't let the tax tail wag the dog. Running a business can be tough enough (trust me, I know) without adding audit worries into the mix. Keep excellent records, seek professional help if you need it and above all, if you do get audited, understand that it's not the end of the world, and know your options.