An audit of a self-employed taxpayer usually centers on Schedule C: whether all income was reported, and whether the expenses claimed are deductible and documented. This article covers what the IRS typically examines, the records that matter most, and what California requires after a federal audit changes a return.
What the IRS Examines on a Schedule C
Income
Some self-employment income is reported to the IRS by clients and payment platforms on forms such as 1099-NEC and 1099-K, but much of it is not. For that reason, examiners test income directly. The Internal Revenue Manual directs examiners to consider gross income in every income tax examination, and its minimum income probes for business returns include steps such as an interview, a tour of the business, reconciling reported income to the books, testing gross receipts, and analyzing both business and personal bank accounts.
Before the first meeting, it helps to reconcile deposits to reported gross receipts and to document any deposits that are not income, such as loans, transfers between accounts, gifts or proceeds from selling personal property.
Expenses
Business expenses are deductible if they are ordinary and necessary expenses of carrying on the trade or business, and the taxpayer must be able to support them. The examiner will typically review a sample of expenses or specific categories and ask for receipts, invoices, canceled checks or statements showing the amount, the date and the business purpose.
Records That Matter Most
- Bank and credit card statements for business and personal accounts
- Invoices, contracts and the Forms 1099 received
- Receipts, canceled checks and vendor statements for expenses
- A mileage log or other vehicle records
- Home office measurements and the related expenses
- Purchase records for equipment and other depreciable assets
If a receipt is missing, a copy can often be obtained from the vendor, bank or card issuer. Records obtained from third parties are generally more persuasive than estimates.
Vehicle Expenses
Vehicles are listed property, so vehicle expenses are subject to the substantiation rules of section 274(d): the taxpayer needs adequate records or sufficient evidence corroborating the taxpayer’s own statement of the business use, the time and place, and the business purpose. Under Treasury Regulation section 1.274-5T(c), a contemporaneous log is not required, but a record made at or near the time of use, supported by documentary evidence, has a high degree of credibility. A statement prepared later needs corroborating evidence with a high degree of probative value.
For 2026, the IRS business standard mileage rate is 72.5 cents per mile for January 1 through June 30 and 76 cents per mile for July 1 through December 31. The standard mileage rate is used in place of actual vehicle operating costs, not in addition to them.
Home Office
A home office deduction is allowed only for a portion of the home used exclusively and on a regular basis for business, and it must meet the other requirements of section 280A. Two methods are available:
- Simplified method: $5 per square foot of the home used for business, up to 300 square feet, with no depreciation deduction for those years.
- Regular method: the business percentage of actual home expenses, including depreciation, which is subject to recapture when the home is sold.
Under either method, the deduction cannot exceed the gross income from the business use of the home less other business expenses. The method is chosen by using it on a timely filed original return, and it can differ from year to year.
Recurring Losses
Under section 183, deductions from an activity not engaged in for profit are limited, so losses from that activity cannot offset other income. An activity is presumed to be engaged in for profit if it shows a profit in at least three of five consecutive years. A business with losses does not lose that status automatically; Treasury regulations look at factors such as whether the activity is run in a businesslike manner, the expertise and the time and effort devoted to it, and its history of income or losses. Business plans, marketing efforts and separate books and accounts help show a profit motive.
Self-Employment Tax and Estimated Payments
An adjustment to net profit generally changes self-employment tax as well as income tax. The self-employment tax rate is 15.3%, made up of 12.4% for Social Security (up to the annual wage base) and 2.9% for Medicare, and an additional 0.9% Medicare tax can apply above certain income thresholds. Individuals generally must make estimated tax payments if they expect to owe $1,000 or more when the return is filed, and an underpayment can result in a penalty.
Respond by the date in the audit letter and organize the records by issue. For audits by mail, the IRS says it can ordinarily grant a one-time 30-day extension; for an in-person audit, the request goes to the assigned examiner.
California After a Federal Audit
According to the Franchise Tax Board’s 2025 Form 540 instructions, if the IRS examines and changes a federal income tax return and the taxpayer owes additional California tax, the changes must be reported to the FTB within six months of the final federal determination. If the changes result in a California refund, a claim for refund must be filed within two years. The report is generally made on an amended Form 540 with Schedule X, together with a copy of the final federal determination and the supporting schedules.
The Bottom Line
A Schedule C audit tests two things: whether all income was reported and whether each expense can be supported. Bank records, invoices, mileage and home office records, and an explanation for nontaxable deposits answer most of the questions an examiner will ask. A federal change can also affect the California return, so the FTB reporting deadline should be calendared when the federal audit closes.
Self-employed and facing an audit?
Tax attorney Cassra Minai, Esq. can review your situation in a confidential consultation.