Because the IRS claims that most tax cheats are in the ranks of the self-employed, it is not surprising that this group is more closely scrutinized than are wage earners. If you are self-employed and the IRS chooses to come after you by way of an audit -- or worse, a criminal investigation -- be aware that the agency can obtain your bank and other financial records. If you've been foolish enough to deposit unreported income in your bank accounts, an IRS auditor may know it.

If you are investigated, expect the IRS to ask the following questions or look into the following issues:

Did you report all of your business sales and receipts?

Did you write off any personal living expenses as business expenses?

Does your lifestyle apparently exceed the amount of self-employment income reported?

Did you write off automobile expenses for travel that was not business-related?

Did you claim large business entertainment expenses?

Are your workers wrongly classified as independent contractors when they are legally employees?

Are you making payroll tax deposits?

Are you reporting all cash transactions -- especially large cash transactions?

Payroll Taxes
If you have employees, always make federal payroll tax deposits when they are due. Never borrow from your employees' tax funds. Even if you eventually make the payment to the IRS, the penalties and interest can be substantial. Pay Uncle Sam first, not last. If you can't pay, then maybe you shouldn't be in business.

One good way to see that payroll taxes get paid on time is to use a bonded payroll tax service to both file and make all payroll tax deposits. Many banks, as well as business called payroll services companies, offer this at reasonable prices. If they goof up and don't get a form or payment in on time, they will pay the late payment penalty.

Cash Transactions
As part of a government campaign against the underground economy in general, and drug-related money laundering in particular, the law requires that cash and cash equivalent business transactions over $10,000 be reported to the IRS on Form 8300. (For a detailed pamphlet explaining this law, see IRS Publication 1544, Reporting Cash Payments of Over $10,000.) These report forms are called Currency Transaction Reports, or CTRs. Some state tax agencies have similar reporting laws and forms.

If you don't file a Form 8300 when you should and the IRS finds out, you can be fined, audited or both. You can also get in trouble criminally -- CTR violations are investigated by the IRS Criminal Investigation Division.

Cash Businesses
If your business deals in a lot of cash -- for example, you run a bar, a restaurant, vending machines or a laundromat -- the IRS may suspect you of skimming cash off your receipts. This is true whether you file Form 8300 or not. The audit potential of cash businesses is much higher than average.

Copyright 2002 Nolo.