What Triggers an IRS Audit
The IRS performs matching functions to reconcile information reported on Forms 1099 and W-2 with information reported on your return. If income reported by you does not meet or exceed amounts reported to the IRS, you will receive either a bill for tax on the difference or an audit notice.
Issues associated with sole proprietorships are commonaudit triggers. The IRS has several approaches to achievean increase in income tax, as well as the assessment ofself-employment tax.
There is a relatively high potentialfor unreported income from cash transactions with soleproprietorships. The IRS will examine your bank recordsto detect deposits that are unaccounted for, compare revenue and expenses of similar businesses, and in somecases will perform a “lifestyle” audit to reconstruct income based on changes in the sole proprietor’s net worth.
Significant losses reported on Schedule C (Form1040), or losses continuing over two or more years, mayincrease the chance of audit. If the IRS is successful inreclassifying an activity as a hobby instead of a for-profitbusiness, losses will be disallowed.