Chances of IRS Audit are Higher for Sole Proprietors

Consider this:
You have a hobby or skill that you have decided, because of retirement, job cutbacks, or other considerations, you want to pursue as a side or small business that will probably generate income. You have received good advice that you should consider forming a single member limited liability company for your new business so that you have some additional personal liability protection and to establish business credit.  You have a choice - either elect to have the new LLC be a treated as a "disregarded entity" (i.e., ignored for income tax purposes) or elect to have the LLC be taxed as a corporation (and, for most individuals, elect to be taxed as an S-Corporation to avoid double taxation).

If you elect the disregarded entity route, things appear easier.  No separate entity is recognized for income tax purposes, no separate tax return needs to be filed and you report your business expenses on your personal return. You are treated, for tax purposes, as a sole proprietor.  If you elect the S-Corporation route, then your corporation has to file a separate return, and your business expenses would be included there.  Your personal taxable income (or loss) arising from your business would be reported on your personal income tax return as Schedule C to 1040.

So, if you make your decision based solely on what appears to be more efficient and less costly from a tax return preparation standpoint, it appears the "disregarded entity" is the way to go.

But wait -

What if you were informed that, in 2008, a sole proprietor was over nine times more likely to be audited by the IRS than an S-Corporation?

The reason for the increased attention given by the IRS to the sole proprietor (e.g., the business electing to be treated as a disregarded entity for tax purposes) may be due to the IRS's conclusion that sole proprietors are far more likely to underreport taxable income than corporations.  The IRS's basis for such conclusion can be seen in some background estimates and data.

The September 2009 report by the Government Accountability Office to the U.S. Senate Committee on Finance entitled "Tax Gap - Limiting Sole Proprietor Loss Deductions Could Improve Compliance But Would Also Limit Some Legitimate Losses" reports the following:

  • Sole proprietors (which include owners of LLCs disregarded for income tax purposes) are estimated to have underreported their net income by 57 percent or $68 billion in 2001 - the most recent year data was available.
  • Sole proprietor tax returns included "substantial misreporting" of both gross income and expenses.
  • 25 percent of sole proprietors reported a loss in 2006, which is a "noticeable proportion".
  • Total sole proprietor losses (adjusted for inflation) grew by 69% from 1996 to 2006. This was a faster rate of growth each year than that of profits and the number of sole proprietor returns filed for the same years except for 2005.

Additionally, Ms. Linda Stiff, the Deputy Commissioner for Operations Support for the IRS, reported to the House Committee on the Budget in July 2007 that there is a net misreporting percentage of over 50% of sole proprietor income and "other income" on individual income tax returns (i.e., the Form 1040).  She further reported that the 2008 IRS initiative to increase tax compliance included a $73.2 million expenditure to "improve compliance among small business and self-employed taxpayers in the elements of reporting, filing, and payment compliance."  This expenditure is estimated to produce $144 million in additional enforcement revenue per year, which means increased funding for increased audits of sole proprietors.

Audits are costly, even if a taxpayer reported everything properly on his or her tax return.  While it may seem unfair that you, an honest taxpayer, should have to consider audit risk mitigation at the time your business is formed, the statistics are what they are.

Because of all this, how your new business will be treated for income tax audit purposes is something you should spend some time thinking about.  The business lawyers at Tydings are here to help you work through this important decision.

If you have any questions regarding your business in Maryland, please contact A. Lee Lundy at 410.752.9705 or via email.

This alert has been prepared by Tydings for informational purposes only and does not constitute legal advice.