If you are self-employed and report a low amount of profit from your business—you could be ripe for an IRS audit.
The IRS has a trick up its sleeve to catch “tax cheats” by attempting to match their lifestyle to the amount of taxable income reported on their tax returns. Don’t be surprised it the IRS invites you in for an audit if you live in a $1 million house with reported income of $30,000 per year!
The “lifestyle audit” is very effective, but unfortunately it also snares honest business owners in the process.
So how does the lifestyle audit work?
IRS computers compare your business profit to other similar types of businesses; along with your deductions, household size, zip code of residence and many other factors.
For example, you reported $30,000 profit from your business, but IRS data determined that you needed at least $49,000 to pay your bills. If you were unable to prove where the money came from to support your lifestyle, the IRS would add additional income to your tax returns based on what it believed you SHOULD have earned.
Of course, IRS computers do not account for the fact that you may live on less than others or have other non-taxable resources (such as child support). Or, perhaps you’ve been financing things with credit cards or getting help from family members. Basically the IRS is auditing you for not making enough money.
And even worse: If the IRS believed that you understated your income by 25% or more, they can audit you back six years instead of the usual three.
There was an interesting story in the news recently about a Donald Dunklee of Michigan, who was audited for reporting $23 in vegetable sales. Mr. Dunklee didn’t even report any expenses against the income, but was audited because the IRS may have believed that he operated a farm and was hiding income.
According to news reports, Mr. Dunklee received $23 from a woman who was driving by his 20-acre property and saw some vegetables she liked in his garden. He refused payment, but she shoved it in his pocket and left. Being honest, Dunklee reported the $23 on his tax return and was audited by the IRS.