When the IRS audits a business, certain issues are of a special concern to it.
Whether all the revenues have been reported is always a point of focus. The IRS has access to bank accounts, so deposited revenues are easy to follow. A personal lifestyle in excess of reported income is a tip off of unreported income.
Personal living expenses deducted as business expenses are a perennial problem for the IRS. Entertainment and auto expenses are particularly subject to review. The rules are manifold.
Payroll taxes are a big potential tax liability for business owners and operators.
Another major issue for business owners is the distinction between employees and independent contractors. An employee is defined by law. The classification used by the employer is not binding on the IRS. The tax liability for incorrectly classifying an employee as an independent contract can easily reach 50% of the employee’s annual salary, so making the correct classification is important. The problem is that there is no simple workable test or definition.
For a starting point of the IRS’s view on what constitutes an employee versus and independent contractor, look at IRS Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
In a nutshell, the IRS uses the following factors to determine that the worker is an employee or independent contractor:
1. You train the worker.
2. The worker works at your business.
3. The worker cannot delegate his or her duties to another person.
4. The worker cannot hire or supervise assistants.
5. The worker must comply with your instructions.
6. The worker has a continuing relationship with your business.
7. The worker has an establish set of hours working for you.
8. The majority of the worker’s work time is spent working for you.
9. You control how the work is performed.
10. The worker must submit regular written or verbal reports.
11. The worker is paid by the hour, week, or month.
12. You pay the worker’s traveling expenses.
13. You furnish most of the tools, equipment or materials.
14. The worker can be fired at will or quit at will.
The following factors are used by businesses to show they have hired independent contractors:
1. The worker hires, trains, and pays their own assistants.
2. The worker is free to work for other businesses.
3. The worker does not work onsite at your business.
4. The worker is paid by the job or receives a commission.
5. The worker can realize a profit or loss.
6. The worker has the worker’s own office, tools, and equipment.
7. The worker has several clients and the worker’s services are available to the public.
8. The worker cannot be fired as long as the work is performed correctly.
This is an area where the IRS is sometimes lax, and sometime vigilant. What passes muster one time, may not pass the next time.