Top Questions for Tax Preparers to Ask to Avoid Audit of Their Self-employed Clients

Top Questions for Tax Preparers to Ask to Avoid Audit of Their Self-employed Clients

Top Questions for Tax Preparers to Ask to Avoid Audit of Their Self-employed Clients

By Tim Frye

When you are preparing a client’s taxes, one of the main snags you want to avoid is raising a red flag in regards to the client, especially if they are a self-employed business owner.  There are certain questions that you need to ask of your client, and certain information you need to gather in order to help the taxpayer avoid an IRS audit.  This article will examine the key questions that can be

asked by the preparer and his or her client in order to understand the self-employed situations that can cause an IRS audit.


How Many Years Can My Client Take a Loss on Their Schedule C Before Raising a Red Flag?

A self-employed taxpayer may possibly arouse the IRS suspicion when they take a loss on their business year after year.  The IRS maintains a provision called the Hobby Loss Rule of Thumb.  If a Business reports net profit for at least three out of the five out of five years, then your client is safe and the assumption remains that the business is under a for-profit classification.  When your self-employed client reports a net loss in excess of two out of the five years of business operations, the IRS will  usually assume it to be a nonprofit hobby business. 

In a circumstance in which your client is indeed trying to make a profit under legitimate circumstances, the taxpayer will merely need to substantiate his expenses to the IRS and business actions in the following arenas. 

-Is the business in existence to make a profit?

-Does the client depend on that income?

-In the case that there are losses, are the losses due to contingencies beyond their control or did these losses occur in the startup embryonic phase of the business?

-Has the taxpayer made any changes or alterations to the business to increase the profits?

-Have profits been made by your client in like-kind businesses in years past?

-Does your client have related expertise in this field of business?

-Is the business at least occasionally in the black and profitable?

-Is a future profit in the business expected and reasonable?

How Much 1099 Income Can My Client Receive Before They Have to Report It?

It is actually a misconception that there are certain floors self-employed taxpayers that they must exceed before they report any 1099 income.  In reality, the IRS requires your self-employed client to report any amount of income, even if it is just $20.  Many clients mistakenly think that if 1099-MISC remains under $600 per payer, the income is not taxable.  This assumption is not correct.  Any payments received by the self-employed taxpayer must be reported in entirety. 

What are op red flags that would cause my self-employed client to be audited by the IRS?

As many experienced tax preparers have come to know, to continue to be in business, you have to be very aware of the red flags that cause IRS audits and be able to help your client navigate these obstacles adeptly.  Let’s take a look at the areas of a self-employed tax return that will cause a preparer’s client to be audited:

The home office deduction

-Disproportionate deductions on meals, travel, and entertainment

-Year after year of income loss, which in turn will cause the IRS to categorize the losses as hobby related?

-Inflated representation of income relative to lifestyle conditions

If you, as the tax preparer, allow your client to represent themselves in such a questionable manner, red flags will surface with immedietly.

What is the Likelihood That My Self-employed Client Will be Audited?

When a taxpayer becomes self-employed, there is no doubt that their return will suffer increased scrutiny.  This is for obvious reasons considering that self-employed taxpayers have much more leniency and freedom when it comes to reporting income and losses. These are returns that are really more based on the honor system. So here are the numbers when it comes to the IRS auditing the self-employed. 

According to studies based on figures from 2011, those taxpayers making less than $200,000, barely one percent can expect to be “examined” by the IRS.  The likelihood of audit of course increases dramatically when a taxpayer puts “oversized” deductions on a return.

In the case in which the taxpayer is earning in excess of $1 Million annually, the chance of an audit has risen rapidly to an alarming rate of 12%. 

Based on figures from 2011, figures show that for those making less than $200,000, only 1% can expect an audit. Obviously, your chances to be that 1% are much greater if your return raises an audit red flag.

In the case in which taxpayers are earning in excess of $200,000, but are not earning more than a million are being audited at a steady rate of 4%.

What Can My Client Expect in Case They are Being Audited?

Many taxpayers suffer from the misconception that when they are audited, the IRS will show up suited in black masked and suited ready to kick your door down while your family sleeps in the night.  Now, not to say that this hasn’t happened here and there, the majority of audits are actually conducted through the mainstream medium of email notice.  In reality, only a mere 25% or IRS audits come in the form of a person to person meeting.  The majority transpire entirely through the old fashioned mail format. 

The key point for preparers and taxpayers to remember is that once an audit is set in motion, over 80% of the taxpayers in question end up paying additional taxes. 

This means that you as a preparer must advise your client to have detailed documentation that supports all their claims. 

If you looking to keep your taxpayers out of the crosshairs of the IRS, you better be sure that you are up on the latest rules and regulations outlined by the IRS, and you can do that by regular checking Pronto Education’s information websites like and  We take pride in helping tax preparers avoid audits.