Independent Contractor Compliance Blog

IRS Auditors Look at More Than Accounting Records When Auditing an IC’s Business

Collabrus works on behalf of client companies to help them safely and cost-effectively engage contingent workers in their business. As such, most of the articles I write are employer-centric. In today’s article I will look at the issue of IC Compliance from the perspective of the Independent Contractor. Specifically, an IC who is being audited by the IRS (not an uncommon occurance in today’s environment).

Of course, it depends on why the IRS auditor knocked on your door, but there are some general truths about an IRS audit you should know.

It’s not just income taxes…

If you are being audited for income tax issues the auditor may also examine employment taxes too, especially in today’s IC compliance environment. The auditor will first look at yours; did you pay your self employment taxes? But in addition, you may be defending any labor or contractor expenses you incurred by sub-contracting work out. You may be asked to prove they were really independent contractors and not your employees.

Be aware that:

1. The burden of proof is on you to prove their status-not the IC or the IRS.
2. The IRS will be looking at the past as much as the present so you may need to prove today what you did three years ago was correct.
3. Once the auditor starts looking at your consultants all of them are likely to be scrutinized.
4. The IRS shares information with the state agencies, so expect your state to follow up if you are out of compliance with the feds.

But there is more…the auditor is also looking at you personally-not just your books and records…

When conducting an income tax audit, the auditor wants to see how your lifestyle matches up with the income reported on your tax return. The IRS refers to this as “economic reality.” In other words, does the way you live match your reported income? The auditor will be observing:

• How you dress,
• If you have expensive jewelry,
• The type of car you drive,
• The home you live in,
• Do you take luxurious vacations to exotic places?

How does the money flow?

If your business handles a lot of cash, the auditor will look for skimming cash before reporting it as income.

If you are using a credit card or debit card for most of your purchases the auditor may track down the source of that card to see if you are hiding money off shore, in a secret account, and then drawing against it with the card.

Business expenses

If you use your personal car for business and deduct expense and depreciation expect it to be challenged. The IRS doesn’t believe personal autos are used 100% for business. It believes everyone uses them to run to the grocery store or the dentist and rarely allows 100% as a business expense. Be able to prove the mileage you claim for business with a detailed mileage log.

Business travel and entertainment expenses are another area where the IRS will challenge you. Be able to prove how they are business related.

There are others, but my best advice is not to get audited.

There are certain red flags that draw the IRS’ (and other enforcement agencies) attention. You need to be sure you aren’t waving those red flags, begging the IRS to audit you. How do you do that? Use an unbiased, third-party expert to do a risk assessment and advise you. It is too difficult to look at your own company objectively and see it the way the IRS will.