12 IRS Audit Red Flags for the Self-Employed
If you are self-employed, minimize the odds of the IRS giving your tax return a second look by avoiding these audit red flags.
Being in business for yourself can be exciting, lucrative – and a great way to draw the attention of the IRS's audit division. The IRS has audited significantly less than 1% of all individual returns in recent years, so most taxpayers can rest easy. But if you file a Schedule C to report profit or loss from a business, your odds of drawing additional IRS scrutiny go up.
Schedule C is a treasure trove of tax deductions for self-employed people. And it's also a gold mine for IRS agents, who know from experience that self-employed people sometimes claim excessive deductions and don't report all their income. The IRS looks at both higher-grossing sole proprietorships and smaller ones. Special scrutiny is given to cash-intensive businesses, highly profitable companies, and small-business owners whose Schedule C's report a substantial net loss (especially if those losses offset in whole or in part other income reported on the return, such as wages or investment income).
You might be aware that the Inflation Reduction Act, passed last year, gives the IRS $80 billion in extra funds over 10 years, with a large chunk of that money to be used by the IRS for increased enforcement activities. Increased audits won’t happen overnight. It will take the IRS time to hire examiners and to train them to audit complicated tax returns. Most of the enforcement effects from the IRS’s $80 billion windfall won’t be felt by taxpayers for at least a couple of years. But you’ll still want to be ready for any IRS audit onslaught because the return you file this year might be snagged up for exam in 2024 or early 2025.
If you want to avoid the wrath of IRS auditors, look at these 12 audit red flags for the self-employed. Doing so now could save you a lot of time and money down the road.
Making a lot of Money
Your IRS audit odds increase dramatically as your income goes up. Sole proprietors reporting at least $100,000 of gross receipts on Schedule C have a higher audit risk. And millionaires face the most audit heat.
The IRS has been lambasted in recent years for putting too much scrutiny on lower-income individuals who take refundable tax credits and ignoring wealthy taxpayers. Partly in response to this criticism, very wealthy individuals are once again in the IRS's crosshairs. The IRS's high-wealth exam squad is even getting back into the action. A specialized group within the IRS tackles examinations of the super-rich. IRS agents take a kitchen-sink approach in auditing these individuals by reviewing not only their 1040 returns, but also returns of entities they control, both foreign and domestic.
And remember, the IRS is getting more money for audits, with $45.6 billion of its $80 billion in extra funding over 10 years dedicated to enforcement activities and collection measures. The Treasury Dept. and the IRS say that the enforcement funds will be used in part to audit more high-net-worth individuals and pass-through entities, such as LLCs and partnerships, among other taxpayers. Treasury officials have made a big promise, saying that taxpayers earning under $400,000 won’t see increased audit rates relative to recent years. The IRS will be hard pressed to keep this promise, but it’s too soon to know for sure.
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.
Taking Excessively Large Deduction on Schedule C
The IRS is suspicious when it sees tax returns with Schedule C attached claiming large losses, and that is especially true if the deductions leading to those losses appear to be excessively large for the business. If your return is chosen for audit, the IRS will be on the hunt to make sure you have the documentation to fully substantiate your big write-offs.
Revenue agents will also want to make sure that there is a valid business purpose for the write-offs and that there’s no shenanigans going on, such as taking deductions for personal expenses.
Make sure that you have a separate bank account for your business and that you have the documentation to support your deductions.
Writing Off a Loss From a Hobby
Not every business ends 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.
The IRS is on the hunt for taxpayers who year after year report large losses from hobby-sounding activities to help offset other income, such as wages, or business or investment earnings. The hobby loss rules are often litigated in the Tax Court. The IRS usually wins in court, partly because it tends to settle cases in which it doesn't believe it can prevail. But taxpayers also occasionally pull out a victory.
To be eligible to deduct a loss, you must be running the activity 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 you're in business to make a profit, unless the IRS establishes otherwise.
The analysis is trickier if you can't meet these safe harbors. That's because the determination of whether an activity is properly categorized as a hobby, or a business is then based on each taxpayer's facts and circumstances. If you're audited, the IRS is going to make you prove you have a legitimate business and not a hobby. Be sure to keep supporting documents for all expenses.
Big Deductions for Meals, Travel and Entertainment
Is it business or pleasure? A large write-off on Schedule C for restaurant tabs and hotel stays will set off alarm bells, especially if the amount seems too high for the business or profession.
To qualify for meal or entertainment deductions, you must keep detailed records that document the amount, place, people attending, business purpose, and nature of the discussion or meeting.
Without proper documentation, your deduction is toast.
Claiming the Home Office Deduction
Entrepreneurs can deduct on Schedule C 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.
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.
Home office deductions are only available to people who are self-employed. If you are an employee, you cannot take a deduction for a home office on your tax return. This is so even in cases where your employer closes your physical office and classifies all workers as remote.
Claiming 100% Business Use of a Vehicle
When you depreciate a car, you must list on Form 4562 the percentage of its use during the year that was for business. Claiming 100% business use of an automobile is red meat for IRS agents. They know it's rare for someone to 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.
Claiming Rental Losses
If your business is real estate, beware – particularly if it's your side business. The IRS actively scrutinizes 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 more than 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.
Taking the Research and Development Credit
The research and development (R&D) credit is one of the most popular business tax breaks, but it's also one that IRS agents have found is prime for abuse. The IRS is on the lookout for taxpayers that fraudulently claim R&D credits and promoters that aggressively market R&D credit schemes. These promoters are pushing certain businesses to claim the credit for routine day-to-day activities and to overinflate wages and expenses in the calculation of the credit.
To be eligible for the credit, a business must conduct qualified research—that is, its research activities must rise to the level of a process of experimentation. Among the activities that aren't credit-eligible: Customer-funded research, adaptation of an existing product or business, research after commercial production, and activities in which there is no uncertainty about the potential for a desired result.
Claiming Day Trading Losses
People who trade in securities have significant tax advantages compared with investors. The expenses of traders are fully deductible and reported on Schedule C (expenses of investors aren't deductible), 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 over the full year and not just for a couple of months. 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. It's pulling returns to check whether the taxpayer is a bona fide trader or an investor in disguise.
Operating a Marijuana Business
Marijuana businesses have an income tax problem. They're prohibited from claiming business write-offs, other than for the cost of the weed, even in the ever-growing number of states where it's legal to sell, grow and use marijuana for medical or other purposes. That's because a federal statute bars tax deductions for sellers of controlled substances that are illegal under federal law, such as marijuana.
The IRS is eyeing legal marijuana firms that take improper write-offs on their returns. Agents come in and disallow deductions on audit, and courts consistently side with the IRS on this issue. The IRS can also use third-party summons to state agencies, etc., to seek information in circumstances where taxpayers have refused to comply with document requests from revenue agents during an audit.
Failing to Report Certain Professional Earnings as Self-Employment Income
Some limited partners (LPs) and limited liability company (LLC) members who don't file Schedule SE or pay self-employment tax are on the IRS's radar. The tax agency has an ongoing audit campaign involving the issue of when LPs and LLC members in professional service industries owe self-employment tax on their distributive share of the firm's income.
In 2017, the Tax Court ruled that members of a law firm organized as an LLC and who actively participated in the LLC's operations and management weren't mere investors and were liable for self-employment taxes. LLC and LP owners in law, medicine, consulting, accounting, architecture, and other professional service sectors are being eyed by IRS examiners, who have been conducting audits over the past few years.
According to the IRS, these ongoing audits have been pretty successful and will continue.
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Receiving Lots of Cash
Do you have clients who pay you big amounts in cash? Businesses must report to the IRS on Form 8300 cash transactions they receive from customers in excess of $10,000.
And if you own a business that deposits lots of cash into the bank at one time, be aware that banks and other institutions must also file reports on deposits in excess of $10,000 in a day or on suspicious activities that appear to avoid the currency transaction rules (such as a person depositing $9,500 in cash one day and an additional $3,000 in cash two days later).
Joy is an experienced CPA and tax attorney with an L.L.M. in Taxation from New York University School of Law. After many years working for big law and accounting firms, Joy saw the light and now puts her education, legal experience and in-depth knowledge of federal tax law to use writing for Kiplinger. She writes and edits The Kiplinger Tax Letter and contributes federal tax and retirement stories to kiplinger.com and Kiplinger’s Retirement Report. Her articles have been picked up by the Washington Post and other media outlets. Joy has also appeared as a tax expert in newspapers, on television and on radio discussing federal tax developments.
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