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All Contents © 2017The Kiplinger Washington Editors
By Joy Taylor, Assistant Editor
| March 2016
Being in business for yourself can be exciting, lucrative — and a great way to get in the sights of the Internal Revenue Service’s audit division. Short on personnel and funding, the IRS audited only 0.84% of all individual returns in 2015. But file a Schedule C to report profit or loss from a business, and your odds of drawing additional IRS scrutiny go up.
Schedule C is a treasure trove of tax deductions for self-employeds. And it's also a gold mine for IRS agents, who know from experience that self-employeds sometimes claim excessive deductions and don’t report all of their income. The IRS looks at both higher-grossing sole proprietorships and smaller ones. Special scrutiny is given to cash-intensive businesses (taxis, car washes, bars, hair salons, restaurants and the like) as well as to small-business owners whose Schedule Cs report a substantial net loss.
Take a look at these eight filing scenarios that could attract unwanted IRS attention.
Is it business or pleasure? A large write-off for restaurant tabs and hotel stays will set off alarm bells, especially if the amount seems too high for the business or profession.
Agents are on the lookout for personal meals or claims that don't satisfy the strict substantiation rules. To qualify for meal or entertainment deductions, you must keep detailed records that document the amount, the place, the people attending, the business purpose and the nature of the discussion or meeting. Also, you must keep receipts for expenditures over $75 or for any expense for lodging while traveling away from home. Without proper documentation, your deduction is toast.
SEE ALSO: Calculator: What's Your Risk of a Tax Audit?
Your audit odds increase dramatically as your business income goes up. In 2014, the IRS examined about 1 percent of small-business filers whose total gross receipts were under $25,000. Compare this to the 2.1% audit rate for businesses with incomes above $200,000. Millionaires face the most audit heat. Last year, 9.55% of taxpayers with incomes of at least $1 million got audited by the IRS.
We're not saying you should try to make less money. Just understand that the more income shown on your return, the more likely it is that you'll be hearing from the IRS.
Not every business comes up in the black every year, but too many years of losses can make the IRS think you’re not really taking your business seriously enough — that it’s just a hobby.
To be eligible to deduct a loss, you must run the operation in a business-like manner and have a reasonable expectation of making a profit. If your activity generates profit three out of every five years (or two out of seven years for horse breeding), the law presumes that you're in business to make a profit. Otherwise, be prepared to answer some tough questions and be sure to keep supporting documents for all expenses.
Entrepreneurs can deduct a percentage of rent, real-estate taxes, utilities, phone bills, insurance and other costs that are properly allocated to the home office. That's a great deal.
Alternatively, you have a simplified option for claiming this deduction: The write-off can be based on a standard rate of $5 per square foot of space used for business, with a maximum deduction of $1,500.
To take advantage of this tax benefit, you must use the space exclusively and regularly as your principal place of business. That makes it difficult to successfully claim a guest bedroom or children's playroom as a home office, even if you also use the space to do your work. "Exclusive use" means that a specific area of the home is used only for trade or business, not also for the family to watch TV at night.
But there’s no getting around the fact that the IRS is drawn to returns that claim home office write-offs. It has historically found success knocking down the deduction. Your audit risk increases if the deduction is taken on a return that reports a Schedule C loss and/or shows income from wages.
When you depreciate a car, you have to list on Form 4562 what percentage of its use during the year was for business. Claiming 100% business use of an automobile is red meat for IRS agents. They know that it's rare for someone to actually use a vehicle 100% of the time for business, especially if no other vehicle is available for personal use.
The IRS also targets heavy SUVs and large trucks used for business, especially those bought late in the year. That’s because these vehicles are eligible for favorable depreciation and expensing write-offs. Make sure you keep detailed mileage logs and precise calendar entries for the purpose of every road trip. Sloppy recordkeeping makes it easy for a revenue agent to disallow your deduction.
As a reminder, if you use the IRS's standard mileage rate, you can't also claim actual expenses for maintenance, insurance and depreciation. The IRS has seen such shenanigans and is on the lookout for more.
Do you have clients who pay you in cash? Like, big amounts? The IRS gets reports of cash transactions in excess of $10,000 involving banks, casinos, car dealers and other businesses, plus suspicious-activity reports from banks and disclosures of foreign accounts. So if you make large cash purchases or deposits, be prepared for IRS scrutiny. Also, be aware that banks and other institutions file reports on suspicious activities that appear to avoid the currency transaction rules (such as persons depositing $9,500 in cash one day and an additional $9,500 in cash two days later).
SEE ALSO: 15 Tax Deductions You Won't Believe Are Real
If your business is real estate, beware – particularly if it’s your side business. The IRS is actively scrutinizing rental real-estate losses, especially those written off by taxpayers who say they are real-estate pros.
Normally, the passive loss rules prevent the deduction of rental real-estate losses. But there are two important exceptions. If you actively participate in the renting of your property, you can deduct up to $25,000 of loss against your other income. This $25,000 allowance phases out as adjusted gross income exceeds $100,000 and disappears entirely once your AGI reaches $150,000. A second exception applies to real-estate professionals — those who spend more than 50% of their working hours and over 750 hours each year materially participating in real estate as developers, brokers, landlords, agents or the like. They can write off losses without limitation.
The IRS is pulling returns of individuals who claim they are real-estate professionals and whose W-2 forms or other non-real estate Schedule C businesses show lots of income. Agents are checking to see whether these filers worked the necessary hours, especially in cases of landlords whose day jobs are not in the real-estate business. The IRS started its real-estate professional audit project several years ago, and this successful program continues to bear fruit.
Those who trade in securities have significant tax advantages compared with investors. The expenses of traders are fully deductible and reported on Schedule C, and traders’ profits are exempt from self-employment tax. Losses of traders who make a special section 475(f) election are treated as ordinary losses that aren’t subject to the $3,000 cap on capital losses. And there are other tax benefits.
But to qualify as a trader, you must buy and sell securities frequently and look to make money on short-term swings in prices. And the trading activities must be continuous. This is different from an investor, who profits mainly on long-term appreciation and dividends. Investors hold their securities for longer periods and sell much less often than traders.
The IRS knows that many filers who report trading losses or expenses on Schedule C are actually investors. So it’s pulling returns to check whether the taxpayer is a bona fide trader or an investor in disguise.
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