If you are still trying to decide whether to operate your business as a sole proprietorship or an entity that provides the benefits of limited liability, recent statistics should help to convince you to incorporate. The IRS consistently places sole proprietorships under greater scrutiny than individuals, corporations, or other business entities. As the table below indicates, the IRS audits sole proprietorships more frequently than any other tax category. Small businesses operated as sole proprietorships are audited at least four times more often than businesses of the same size that are operated as corporations or partnerships. And, word recently has leaked from the IRS that sole proprietorship audits are going to increase.



1) Figures refer to individual total positive income between $25,000 and $100,000, and total positive income of $100,000 or more.
2) Figures provided refer to Schedule C filers (including sole proprietors and other self-employed filers) reporting between $25,000 and $100,000 total gross revenue, and over $100,000 total gross revenue.
3) Figures provided refer to all partnership returns filed under Form 1065.
4) Figures provided refer to all S corporation returns filed under Form 1120S.
5) Figures provided refer to the average IRS examination/audit rate for corporations reporting under $250,000 in assets on their balance sheet returns.
6) See Internal Revenue Service 2001 IRS Data Book: Publication 55B <http://www.irs.gov/pub/irs-soi/01db10ex.xls> (published Mar. 18, 2002).

Source: Internal Revenue Service Tax Statistics: Examination Activities <http://www.irs.gov/taxstats/ display/ 0,,i1%3D40%26genericId%3D16905,00.html> (accessed June 10, 2002).

• The Nature of Sole Proprietorship Income – Sole proprietorships are naturally smaller and more reliant upon cash income than other forms of business. A sole proprietorship’s cash income is not generally subject to third party reporting. Although not all people would take advantage of this situation by underreporting income, it is easier and more common for sole proprietors to do so than it is for other taxpayers. To ensure compliance with tax laws, the IRS focuses a disproportionate amount of its enforcement energy on sole proprietors.

• Home-Office Deduction – Although many self-employed persons or sole proprietors may qualify for home-office deductions, the rules governing the deduction are so complex that the IRS may use this deduction as a red flag in determining whether an examination is warranted. The potential for mistaken or fraudulent use of this deduction justifies heightened scrutiny by the IRS, especially when taken in combination with the nature of sole proprietorship income.

• Travel, Entertainment, and Miscellaneous Expenses – A sole proprietor who claims travel, entertainment and/or miscellaneous expenses as a deduction on their tax return calls the IRS’s attention to their return. It may be difficult for the IRS to believe a sole proprietor who claims deductions for such expenses.

• Business Losses – Repeatedly claiming business losses could suggest to the IRS that a sole proprietor is not in business to earn money, but to provide tax benefits for a personal hobby. Unlike businesses that have been incorporated, sole proprietorships do not require annual filing fees or other expenses that would confirm the existence of a separate business. Accordingly, the IRS will likely take greater notice if a sole proprietorship continually produces losses.

• Changes Within the IRS – Congress has told the IRS that it cannot audit randomly. Accordingly, the IRS had to create some basis for its auditing decisions. The foregoing considerations have emerged as possible tools for the IRS. In addition, recent restructuring within the IRS may produce greater scrutiny of small business. The Small Business/Self-Employed Operating Division was created to focus on sole proprietorships, as well as all other business entities with less than $10 million in assets. The Division was intended to increase compliance with tax laws. This indicates a possible increase in the amount of audits performed on small businesses and may result in even greater scrutiny of sole proprietorships in the near future.

Although the IRS has not explained why it audits sole proprietors more frequently than other business owners, the statistics show that other business entities are audited with less regularity. In the decision of whether to operate a business as a sole proprietorship or a different business entity, the risk of an audit is one among a number of factors to consider. However, the risk may be enough to tilt the balance in favor of an entity that will provide its owner with limited liability.

Another reason that incorporating your business may make sense is because it can be much easier to build business credit with a corporation than as a sole proprietor. If you want to build a business credit profile so you can borrow without personal guarantees, choosing the right business structure is critical. For more information on business credit and other related issues, visit our home page at www.BusinessCreditSuccess.com.

The information provided herein does not constitute legal advice and cannot replace the services that accountants and attorneys provide. Arming yourself with knowledge may allow you to use such services more efficiently. For more information about business entities, and to learn more about developing your business for success, see "Own Your Own Corporation: Why the Rich Own Their Own Companies and Everyone Else Works for Them", (Warner Books 2001) and “How To Use Limited Liability Companies and Limited Partnerships”, (SuccessDNA 2004) both by Garrett Sutton, Esq. You may also visit www.successdna.com and www.sutlaw.com for additional information.

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