Six Steps to a Safer Schedule C

In a prior article, we discussed an overview of issues relating to Schedule C.  In this article we will offer some guidelines for the proper preparation of a Schedule C along with some tips help avoid an audit.

First and foremost, submit a complete Schedule C.  This includes completing all sections of the form including your accounting method, your business code, whether you materially participated, and if you started or acquired the business in the current year.

Second, be sure to place expense items in their proper places on the Schedule C.  Place as few items on line 27 – other expenses – as possible.  If there is a specific line item for the expenditure, place that amount there, not in “other expenses.”  For example, line 23 if for taxes and licenses.  Property taxes, employment taxes, business licenses all should be included here.

The third step is to have accurate and complete records and documentation of your income and expenses.  To help you do this, you should have a separate checking account for your business and deposit all receipts in the account.  Keep receipts for all expenditures, along with a mileage log for business travel.    An excellent investment in this regard is a good software accounting program, such as QuickBooks.  This will show the auditor that you keep good records and are organized in how you approach your business.  Additionally, it helps insure that you keep up with your expenses and do not accidentally omit a legitimate expense.

Fourth, if it is a legitimate expense that you incurred in your business, deduct it.  Many people will fail to deduct an expense because they fear it might raise a red audit flag.  Instead of omitting it, document it.  Automobile expenses, meals and entertainment, and home office deductions are among the most common items that invite IRS scrutiny.  They don’t want to deny a legitimate deduction, but you must be able to prove that it was incurred in a business context.

Automobile expenses should be evidenced by a “contemporaneous log” that includes mileage and date driven, the purpose of the trip, and where you went.  You can deduct the IRS standard mileage rate or you may choose to deduct actual expenses.  Meals are deductible for out-of-town travel.  Entertainment expenses must be related to the business in order to take a deduction.  Business may be discussed before or after the entertainment event.  Meals and entertainment are limited to 50% of their cost.  For meals consumed during travel, you may choose to use the IRS per diem amounts.  It is a common misconception that the IRS has a per diem amount for lodging.  As proof, it is often cited that there is a federal per diem rate at www.gsa.gov/perdiem.  This lodging per diem rate is not an allowed amount for income tax purposes, it is the rate the federal government will reimburse its employees.

A home office deduction is allowed for a business owner if there is an area in the home that is used regularly and exclusively for business purposes.

Fifth, you should consider having your return prepared by an enrolled agent or CPA.  Self-prepared returns are more likely to be audited because the IRS believes that a nonprofessional is more likely to take a deduction that is not allowed.

Finally, you should be aware that if you show a profit in three out of five years there is a presumption that the activity is one that is carried on for profit.  Failure to earn a profit in three of five years does not automatically make your activity a hobby; it simply means that you have a greater burden of proof to convince the IRS that you have a legitimate business activity with a profit motive.

These steps will help you avoid an audit, but they are not foolproof.  Despite your best efforts, you may get a letter from the IRS one day, informing you of an impending examination.  If you have followed these six steps, it should minimize any trauma from the audit and help you successfully negotiate it.  As a final reminder, the IRS never contacts taxpayers by e-mail, you will learn of an examination by letter.  If you get an e-mail that is supposedly from the IRS, hit the delete button immediately.