Audit Selection

• The IRS selects most returns for exam in one of three ways. These include random selection, data mismatch and related exams. Random selection is a process where the IRS selects returns for exam at random. There may be no known reason for these returns to be audited. Data mismatch audits occur when information claimed by a taxpayer does not match data the IRS receives on behalf of the taxpayer from other parties, such as wage and compensation information from a W-2. If you receive 1099-MISC income and do not report the amount on your Schedule C, this may be a reason for your return to be audited, but having a loss on your Schedule C would not be the reason. Related return exams occur when a tax return being audited is related to another person's activity. For example, if a corporate tax return is audited, the IRS may audit the personal tax returns of the corporation's officers. This is not a concern for Schedule C filers.
  
  

Hobby Income

• Hobby income is money generated by a taxpayer's own production outside of a contract position or regular job. Often, hobby income is confused with self-employment activity claimed on Schedule C. Unfortunately, some taxpayers use Schedule C to claim personal expenses that are not related to actual business activity. The result is an intentional Schedule C loss, created to offset income from other sources. If the IRS notes significant Schedule C losses on your return in consecutive years, your return may be selected for audit. Your Schedule C income may be converted to hobby income if you claim losses for more than three years in a five year period. If your Schedule C income is classified as hobby income, any Schedule C expense you claim is disallowed. Income tax is due on the entire amount of hobby income.
  
  

Recordkeeping

• If you are a sole proprietor or receive 1099-MISC income that you must claim on Schedule C, keep records and receipts for all your business transactions. If possible, open a separate bank account to process business deposits and expenses. This separates your personal activity from your business activity. In the event you are audited, it is easier to prove business expenses and other transactions when there is a distinct separation between business and personal funds. Keep receipts, bank statements and customer invoices with your tax return for easy access. In most cases, the IRS must perform audits within three years from the date a return is filed.
  
  

Audit Process

• If your return is selected for audit, the IRS notifies you by mail or phone of the tax year that will be examined. If the notice indicates you must mail information to support items on your return, you must make copies of your records and mail the package to the IRS by the due date indicated in the letter. If you miss the due date, the IRS may create additional tax assessments based on no proof of your expenses. If you are selected for an in-person audit, your notice instructs you to contact the examiner named in the letter to schedule a date and time to meet and produce your records.