Posts Tagged ‘irs audit’

Part 1:  Gross Receipts and Cost of Goods Sold

Ever wonder what makes the “tax man” tick?  Unfortunately for you sole proprietors out there, you’re a high profile target for an IRS inquiry or examination.  The IRS has concluded that the most frequent contributors to noncompliance and false reporting are the small business taxpayers.  Based on what IRS examiners have found, roughly 60% of sole proprietors underreport their net business income.

So how is it possible to avoid getting a lovely examination letter in the mail from the IRS?  In short, you can’t.  However, you can limit your exposure by accurately and consistently reporting your business activities.  The main purpose for accuracy is not only honesty, but in the event of an IRS examination you will have nothing to be concerned about.

The first 2 points of emphasis are Gross Receipts and Cost of Goods Sold.

1)      Gross Receipts – What are considered gross receipts?  If there is any connection between any income received and a business, it’s considered business income and must be reported.  A Form 1099-Misc will usually be sent to the sole proprietor if amounts received were for $600 or more for services performed.  A copy is also sent to the IRS, so if your gross receipts on the Schedule C are less than the total from reported 1099’s…you may have just red flagged yourself.

a)      A good rule of thumb for those who don’t keep accurate records would be to go through the business’ bank statements for the year and add up all deposits.  Those deposits should be close to what is reported as gross receipts on the schedule C.  (WARNING:  separate your personal and business bank accounts.  You don’t want deposits to your personal account to be considered business income.)

2)      Cost of Goods Sold (COGS) – The simple formula for COGS is (beginning inventory + purchases + related labor costs + related materials and supplies – ending inventory).  Unless the sole proprietor is a manufacturer or involved in mining operations, the only parts of this calculation that will be used are inventory and purchases.

a)      Are you a sole proprietor with average annual gross receipts of $1 million dollars or more?  You may need to report on the accrual basis of accounting.  Contact your tax preparer for more information regarding proper accounting methods.

At the end of it all, your Gross Receipts minus your COGS will give you Gross Profit.  If everything is being reported accurately and consistently, the percentage of Gross Profit over Gross Receipts (gross profit percentage) should be relatively consistent from year to year.

Up next for the Schedule C “Hot Buttons”, Part II – Automobile Expenses and Contract Labor.