Self-Employed? Watch Out for These IRS Audit Red Flags
If you're in business for yourself, minimize the odds of the IRS giving your tax return a second look by avoiding these audit triggers.
Being in business for yourself can be exciting, lucrative – and a great way to draw the attention of the IRS's audit division. Short on personnel and funding, the IRS has audited significantly less than 1% of all individual returns in recent years. 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 (taxis, car washes, bars, hair salons, restaurants and the like), people with freelance service gigs through the sharing economy (think of Uber and Grubhub), 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).If you want to avoid the wrath of IRS auditors, take a look at these 11 filing scenarios that could attract unwanted IRS attention. Doing so now could save you a lot of time and money down the road.
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.
Making a Lot of Money
Your 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 if President Biden gets his way, more upper-income individuals will be audited. He wants Congress to give the IRS billions of dollars for the agency to step up its enforcement efforts against wealthy individuals, large corporations and passthrough entities, such as partnerships and LLCs. The Treasury Department says that the president's proposal won't cause audit rates to rise for individuals with incomes below $400,000. Congressional Democrats have proposed in their Build Back Better bill to give the IRS $80 billion over 10 years for enforcement and other activities, but that bill is now stalled in the Senate amid infighting among Democrats.
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 Making Enough Money
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 have also pulled out a victory in a number of court cases.
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.
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.
Claiming 100% Business Use of a Vehicle
When you depreciate a car, you have to 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 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.
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. 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.
Engaging in Currency Transactions
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 a person depositing $9,500 in cash one day and an additional $9,500 in cash two days later).
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 & 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.