Despite the news about all those new IRS agents, the truth is that the IRS has audited significantly less than 1% of all individual returns in recent years. Hiowever, if you file a Schedule C to report profit or loss from a business, your odds of drawing additional scrutiny goes up significantly.
So what are the reasons why the self-employed get audited?
While there isn't a definitive list, here are some of the things they look out for:
1. Excessively large deductions
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. The IRS uses data that show the average expenses per income for most types of businesses and if your ratio is outside of those parameters, it will through up a red flag.
That doesn't mean you shouldn't take large losses, but if you do make sure you have the documentation to back them up that show they were actually a business expense and you aren't mixing personal expensing among them. Having a separate bank account for your business helps with that documentation.
2. You make a LOT of money
Even though overall individual audit rates are low, your audit odds go up as your income goes up, especially if you report business income on a Schedule C.
Remember, congress gave the IRS is getting more money for audits over the next 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.
Under the previous administration, officials made a huge 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.
That sound good on camera, but the truth is that I have seen more audit letters in the last couple of years for small businesses than in the previous two decades. These correspondence audits normally are requesting proof of the expenses you claimed on the Schedule C - especially the standard mileage deduction. Generally the more income, the more deductions and the greater your chance of audit.
I'm not saying you shouldn't try to make more money. Just understand that more income means there is a greater chance that you'll be hearing from the IRS.
3. Claiming hobby losses
The IRS is actively looking for people who year after year report large losses from hobby-sounding activities that offsets other income, such as wages, or business or investment earnings. Simply put, you cannot claim losses against hobby income. So, how do you prove your little business is not hobby income? According to the IRS:
- 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.
If you can't meet these safe harbors, determining whether an activity is properly categorized as a hobby or a business is based on each taxpayer's facts and circumstances and you will have to prove you have a legitimate business and not a hobby.
4. Claiming 100% vehicle business use
The IRS knows 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, because these vehicles get favorable depreciation and expensing write-offs.
Make sure you keep detailed mileage logs. The mileage log must be a day-by-day list of the number of miles driven that day and what makes them business miles, such as the client visited or other activity that supports your business. There are some great apps that can help you with that.
5. Trading in securities
People who trade in securities have a lot of 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. Plus other tax benefits.
A trader buys and sells securities frequently and tries to make money on short-term swings in prices. The trading activities must be continuous over the full year and not just for a couple of months.
An investor 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. The passive loss rules
The IRS actively scrutinizes rental real-estate losses, especially by those claiming they're real-estate professionals. This is because the passive loss rules prevent the deduction of rental real-estate losses - with 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. OR
- Real-estate professionals 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.). They are are checking to determine if these filers worked the necessary hours, especially in cases of landlords whose day jobs are not in the real-estate business.
7. R&D credits
The research and development (R&D) credit is one of the most popular business tax breaks and is prime for abuse. There are 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 over inflate wages and expenses in the calculation of the credit.
To qualify for the credit, a business must conduct qualified research - which means that its research activities must rise to the level of a process of experimentation. You can't use customer-funded research, adaptation of an existing product or business, research after commercial production, or activities in which there is no uncertainty about the potential for a desired result.
8. Marijuana businesses
Marijuana businesses currently have an income tax problem. They're not allowed to claim 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. This is because there is a federal statute that bars tax deductions for sellers of controlled substances that are illegal under federal law, such as marijuana.
The IRS is looking at 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, it is not clear what the Trump administration's view on this will be. If the rules are changed, marijuana businesses in states in which cannabis is legal could deduct business expenses on their federal tax returns.
9. Meal and travel deductions
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 type of business or profession you are in.
If you want our business 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 will be thrown out by the IRS.
10. Home-office deductions
Small businesses 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. In fact sole proprietors or S-Corporations & partnerships with accountable plans are the only ones who can claim the home office deduction.
Instead of adding up all those bills to figure the deduction, there is also 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. Whether you use either method, their are some rules that apply:
- 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.
- You must be self-employed
- You can't take the deduction if you are a W-2 employee even if you are working remotely.
The IRS is drawn to returns that claim home office write-offs and 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.