By Lou Carlozo
This past New Year’s Eve, any impulse I had to ring in 2012 on a high note was drowned out by alarm bells from Uncle Sam.
On that day, my wife and I received separate eight-page letters from the Internal Revenue Service informing us that we were being audited for the 2009 tax year. It was, to say the least, no cause for breaking out champagne and noisemakers. In fact, it seemed like a cruel twist: 2009 was the year I was laid off by the Chicago Tribune after 16 years of full-time employment. I then entered the freelance ranks, where I’ve remained ever since.
Honest taxpayers hit with IRS audits will ask themselves, “Why?” This freelance journalist is asking the same thing — and the “why” comes with an itch to dig for answers to share with readers. I suspected my story would fit into a larger narrative about who gets audited.
So I read up, watched some videos, and talked to tax experts. I also called the IRS media office; when I described my story, one good-natured spokesman joked that he couldn’t help with my audit, just audits in general. Ha ha.
Here’s what I learned: Self-employed people and freelancers get audited more — a lot more, it turns out — but there are good reasons for this.
In 2008, my last year of full-time employment for a company, 26 percent of employees listed themselves as free agents, according to the Kelly Services 2011 Free Agent Survey. (Free agents are individuals who consult, perform temporary, freelance or contract work, or have their own business.) Since then, their numbers have exploded, with more than four out of 10 employees in the free-agent pool.
Experts say that with more free agents than ever, the I.R.S. wants to take a close look at the growing numbers and make sure they’re doing their taxes correctly.
SMALL BUSINESSES ARE TARGETS
In 2010, 23 million taxpayers filed a Schedule C — which sole proprietors (such as freelance journalists) use to report profit or loss on an unincorporated business.
“If you go to the actual IRS statistics, the chances of a Schedule C being audited are twice as great as a corporation being audited,” says Keith Hall, a tax adviser for the National Association for the Self-Employed, in Washington D.C.
Now, adjust those figures to exclude small businesses under $25,000 in gross receipts, and here’s what you’ll find: Roughly 3 percent of small businesses under Schedule C get audited, compared to 1 percent of corporations.
So if you’re a sole proprietor, you’re almost three times as likely to get audited as a corporate filer, Hall says. And he should know: He’s been audited, twice. And both times, in 2004 and 2005, he didn’t owe the IRS an extra dime. (More on that in a bit.)
“It is my opinion that the IRS does target small business owners for audit,” Hall says.
And the IRS practically admits as much in a ten-part video series on line, “Your Guide to an IRS Audit.” (I’m also a freelance recording studio owner, and for a moment I wonder about re-recording the video series’ theme music for the IRS in exchange for being let off the hook for whatever I may owe them. The music sounds ominous and odd at the same time: a smooth-jazz pseudo-Bach fugue played on a plinky ’80s lounge synthesizer.)
That video series dramatizes the plights of three audited taxpayers; and guess what? All of the stories involve an individual who operates his or her own business.
MORE ERRORS AND OMISSIONS
If the IRS leans toward auditing small business owners, “It’s not because they don’t like us,” Hall says. “It’s that they find more errors and omissions.”
Hearing this, I wanted to beat myself up for not quadruple-checking my numbers or recording my mileage down to the nearest tenth of a mile. But am I being unfair to myself? Or, is the IRS potentially taking advantage of a liability I have as a Schedule C guy? That could be, Hall says.
Unlike many corporations, “The small business owner doesn’t have a CPA or a staff of accountants,” Hall notes. “And because the tax code is so complicated, it is much easier for the small business owner to make a mistake.”
Then again, some of those “mistakes” may be intentional.
“Many small business owners and self-employed taxpayers have some or most of their income reported to the IRS, but they deduct a lot of expenses that aren’t subject to third-party reporting,” says Rebecca J. Wilkins, senior counsel for federal tax policy at Citizens for Tax Justice, in Washington D.C. “So there are lots of opportunities to overstate those deductions and lower their tax bills.”
And so I learned a parting lesson that I should know well as a journalist: The facts don’t lie. In surviving two audits unscathed, Hall produced a receipt or document to back up every deduction he made, and every line item on his tax return. I asked him for the key page from his playbook, and it’s one that you can use should the taxman call you in.
“Pull out your tax return and redo everything,” he advises. “In the audit letter, the IRS will ask you everything they’re looking for. You have to build your own little paper fort to answer those questions, and a lot of banks have digital records to support the numbers on your tax return before you go in to visit the IRS.”