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Why tax audits target self-employed taxpayers

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The estimated "tax gap" is $458 billion each year. This is the difference between what is owed and what the IRS collects. Approximately a quarter of this is due to unreported business income.

Sole proprietors who pay taxes on their business income through their personal tax returns can fall into this category. The New York Times recently discussed "low visibility" income. About 60 percent of this income (cash payments or payments unreported by outside parties) is not disclosed by business owners.

How the IRS tries to ferret out unreported income?

Tax audits are the traditional tool the IRS uses to find unreported or underreported income. Short on resources, the amount collected from tax audits actually fell to a 13-year low of $7.3 billion last year. 

Who are the people most likely to underreport income?

The Taxpayer Advocate Service has been studying how to get small-business owners to accurately report their earnings. It has found some interesting themes:

  • Those suspected of dodging taxes are clustered in certain geographic areas (the South and West - California, Georgia and Texas top the list)
  • Business owners active in local communities were more likely to underreport income on their federal tax returns (this may be related to a stronger association with local rather than federal government)
  • Self-employed people who went through an audit were less likely to report all income in subsequent years.

The IRS uses an algorithm to identify how likely a taxpayer is to underreport income. A higher score correlates with a higher risk of an audit. This may not be perfect. Of 1.2 million audits in 2014, only 13 percent resulted in a tax adjustment.

In an era of lagging resources, self-employed individuals continue to receive quite a bit of agency attention. Even when an audit does not result in a surprise tax bill, the audit process itself is costly and time consuming. In our next post, we will share tips for surviving an audit.

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