Ten IRS Audit Red Flags for Self-Employed Individuals

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.

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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).

The Inflation Reduction Act gave the IRS $80 billion in extra funding over ten years, with a large chunk of that money going to increased enforcement activities. This money is in addition to the IRS's annual funding.

Congress has since clawed back about $25 billion of that windfall, with another potential $20 billion on the chopping block, and Republican lawmakers are promising to slash it even more.

Reasons why the self-employed get audited

There's no sure way to predict an IRS audit, but if you're self-employed, these ten "red flags" could increase your chances of drawing unwanted attention from the IRS.

1. Taking excessively large deductions

If the deductions, losses, or credits on your Form 1040 are disproportionately large compared with your income, the IRS may want to take a second look at your return. The same is true with deductions taken 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 are 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.

2. Making a lot of money

While overall individual audit rates are low, your audit odds go up as your income goes up, especially if you have business income reported on Schedule C.

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, wealthy individuals are once again in the IRS's crosshairs.

Remember, the IRS is getting more money for audits, with a significant chunk of its extra funding over 10 years dedicated to enforcement activities and collection measures. The Treasury Department and the IRS say that some enforcement funds will be used to audit more high-net-worth individuals and pass-through entities, such as LLCs and partnerships, among other taxpayers.

During the Biden administration, Treasury officials and the IRS made a big promise that individuals and small businesses earning under $400,000 wouldn't see more audits compared to historic rates. That applied only to taxpayers with total positive incomes of less than $400,000, meaning income before taking losses and deductions on their federal tax returns.

• The IRS isn't considering hiking the $400,000 figure for couples filing a joint tax return.
• The agency says the audit rate on 2018 returns will be used for the historic rate comparison, which is good news for taxpayers.
• The overall audit rate for 2018 returns was 0.3% for individuals.

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.

3. Writing off a hobby loss

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 determining whether an activity is properly categorized as a hobby or a business is based on each taxpayer's facts and circumstances.

If you're audited, the IRS will make you prove you have a legitimate business and not a hobby. Be sure to keep supporting documents for all expenses.

4. 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.

5. Trading vs. investing in securities

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.

6. Claiming rental losses

The IRS actively scrutinizes rental real-estate losses, especially those written off by taxpayers who say they are real-estate professionals.

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. Real-estate pros 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, can write off their rental losses without limitation.

The IRS is pulling returns with large rental losses taken on Schedule C by individuals who claim they are real-estate professionals, and whose returns also report lots of income from other sources (wages, investment and retirement income, non-real estate businesses, etc.). 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.

7. Taking the R&D 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 who fraudulently claim R&D credits and promoters who 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 are 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.

8. 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.

Former President Biden's administration proposed rules to reclassify marijuana from a Schedule I drug to a Schedule III drug under the Controlled Substances Act. If the rules are adopted as final, marijuana businesses in states in which cannabis is legal could deduct business expenses on their federal tax returns. It is unclear how President Trump plans to handle this.

9. Big deductions for meals and travel

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 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.

10. Claiming home-office deductions

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 a 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.

Currently, 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.

Related Content

• What Are Your Chances of an IRS Audit? 18 Audit Red Flags
• Understand These Hobby Loss Rules to Reduce IRS Audit Risks
• Home Office Tax Deduction: Work-from-Home Write-Offs