- If you’re being audited for your freelance business, this article will give you the basic information that you will need for your audit. There may be other issues that will be covered in your audit as well.
- If you’re not being audited for your freelance business, this article will give you a preview of what you will need should an audit letter come to you and will allow you to prepare your taxes and keep your records so that an audit letter will not mean an inordinate time spent preparing for your audit.
The first you will hear about an audit is in a letter from the IRS or whatever state or local taxing authority you file with. This article will only deal with the IRS and audits for freelance income.
Regard this IRS letter as your instruction sheet that you must adhere to as closely as possible in order to have a successful audit. It is important you read every line and regard each request as something you must fulfill to your utmost. The letters vary about what the agent will deal with at the audit.
The audit may take place through the mail or in person.
You may or may not be asked about each thing you’ve prepared for the audit. Because you don’t know what will be addressed, each item must be prepared as thoroughly as possible. My sense is that you or your representative will be judged on the first one or two items asked. If your receipts or income match what is on the tax return, the rest of the audit may go a bit easier.
A successful audit will be different for different people. For some, it’s one where the person finishes the audit in a short period of time and is told they have a “no change” which means they don’t owe anything. For others if what they owe is less than they feared, they have succeeded. And for still others, it’s getting back money.
Preparing for an audit is more or less arduous depending on how the person has prepared their taxes and kept their records.
Some people are so angry at being audited that they go into the IRS with their negative feelings. While I understand these feelings of anger, I don’t believe it does you any good to bring anger to the audit. For most agents I have dealt with, a calm, respectful, businesslike demeanor works better along with thorough preparation. Another attitude is one of “I’m an artist, I shouldn’t have to go through this” which also doesn’t work very well. You have presented yourself to the IRS as a business. The IRS expects you to have all your receipts, records and invoices regardless of what business you’re in.
I do find it helpful to bring in a resume and samples of the artist’s work reprinted in books and magazines to give the agent a sense of what you do. This is especially true for those people who have taken losses in their businesses and have to show that they are indeed in the business they have said they are in.
An appointment must be set. The IRS letter will give you the name of the agent and his or her phone number to call to make an appointment. Before you call, see what is being requested and how well you are prepared so you can set a date that is reasonable for you or your representative to go and present your materials in a complete way. The letter will tell you what year is under audit and what information is being asked for.
Typically, you will be asked for copies of your tax returns for the year under audit, the year before and the year after. You will not initially need to bring anything but these copies for the year before or after but the IRS holds open the right to open up those years should the IRS agent so choose.
You could be asked for copies of all your bank statements, your brokerage statements and your credit card statements for the December before the year being audited, the year being audited, and the January after the year being audited. These are useful to the agent for two major reasons: to check the amounts of money deposited into your accounts and to verify expenses that you’ve claimed.
You could be asked for logs and notes that you used to prepare your taxes. A datebook for the year under audit is useful to bring. Make sure that any travel that you deducted is reflected in the datebook as well as corresponding business meals. In other words, if you deducted a trip to San Francisco for a conference and your datebook only has local entries, an agent might regard the trip with suspicion.
You could be asked for invoices, 1099’s and other ways you used to determine your income. Add up the invoices again and attach a tape of the numbers to the clipped invoices to show the agent. Add up all the deposits into your various accounts. If there is a difference, determine the cause of the difference. If you received outside gifts, you might bring a letter from the people giving you the gifts so that it is clear that this money is not income. There may be a difference between what you received from 1099 clients and what was deposited. You may have a check that was received in the following year although it was included on the 1099 for the year being audited. Show the agent how the difference was deposited the year after because it was received in that year. Also if you have shared accounts, sometimes spouses write each other checks that the IRS thinks are income. Bring a list of these and copies of the checks to show that these checks weren’t income but simply intra-family transfers.
The IRS will ask for proof of different expenses. The bottom line is that you should have proof of purchase and proof of payment for each expense. This means that there is a receipt or invoice and either a check or a copy of the credit card statement you put it on for each expense.
A credit card statement by itself is not enough. You have to show what was bought with that payment. There may be some small things that are paid with cash for which you have a receipt and that’s fine. There may be some things that you do not have proof for as with certain taxi rides or magazines. In this case, the expenses should be listed in your datebook or on a separate page and it is up to the discretion of the agent about whether or not to accept the expense.
Getting copies of the checks is the way to show proof of payment on a checking statement unless the statement shows to whom the check is made. This is why having paper checks is advantageous. And why you should keep copies of your checks and those photocopies of the checks that are sent out.
I personally attach a copy of each check or each credit card payment to the receipt or invoice for each expense in each category. This means that the agent doesn’t have to rifle through your checking and or credit card statements to find a single payment. I am then able to hand over each category of receipts and invoices along with a tape total which hopefully match what is on the Schedule C.
Each category of expense that is requested should be presented separately, in chronological order if possible. A tape of the expenses with the total could be attached to show that it matches the number given on the tax return.
Too many people expect the IRS agent to plow through piles of receipts, organize them and come up with a result that is one that the taxpayer will like. While this is possible, I wouldn’t encourage it. My method is to be as thorough as possible, in order to take as little time of the agent as possible. Also, my experience is that the more methodically and completely prepared the material is put together, the more chance that the agent will be flexible about an item here or there that might be missing and the better the result.
For specifics regarding different expense areas, go to www.irs.gov.
- For travel, car and meal expenses, go to Publication 463.
- For home office issues, go to Publication 587.
- For general business expenses, go to Publication 535.
When should you use a professional to help you with your audit? While I am confident that there are some people who do not need to consult a professional to get through this process, I believe that most people would benefit from either having a tax preparation professional who has experience with audits either represent them at the audit or help them prepare for the audit. In situations where records are not complete, where losses have been taken for more than two out of the past five years, where income has been underreported, or where you are not confident of what’s on your tax return or your audit preparation, consultation or representation might be a good idea.