The IRS has audited only 1% of all individual returns recently, so most taxpayers can sleep at night. But if you file a Schedule C to report profit or loss from a business, your odds of drawing additional IRS scrutiny increase.
Schedule C is a “gold mine” of tax deductions for the self-employed. IRS agents know from experience that self-employed folks often claim excessive deductions and don’t always report all their income. Agents look at high-grossing sole proprietorships, scrutinize 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 such as wages or investment income.
Avoid the wrath of IRS Agents by becoming familiar with these audit triggers:
- Making a Mountain of Moolah: Treasury officials made a big promise that taxpayers earning under $400,000 won’t see increased audit rates relative to recent years. But they will be hard pressed to keep that promise, because audit odds increase dramatically as your income goes up, and sole proprietors reporting at least $100,000 of gross receipts on Schedule C are in their sights as much as wealthy taxpayers. Agents will review not just your 1040 returns, but also the returns of entities you control.
- Excessive Deductions on Schedule C: Schedule Cs claiming large losses attract attention, especially if they are deemed in appropriate for the business. Make sure you have the documentation to fully substantiate your big write-offs. Be sure there is a valid business purpose for all write-offs and do not be tempted to take deductions for personal expenses. Having a separate bank account for your business may be helpful.
- Disguising a Hobby: Too many years of losses can make the IRS think you’re not really in business, that it’s just a hobby for you. The IRS is on the hunt for taxpayers who report large losses from hobby-like activities to help offset other income, such as wages, or business or investment earnings. 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.
- Is It Entertainment for 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.
- Home Office Deduction: Home office deductions are only available to people who are self-employed. 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. If you are an employee, you cannot take a deduction for a home office on your tax return, even if your employer closes your physical office and classifies all workers as remote. To take advantage of this tax benefit, you must use the space exclusively and regularly as your principal place of business. You cannot claim a guest bedroom 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.
- 100% Business Use of a Vehicle: Claiming 100% business use of an automobile is a red flag for IRS agents. 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 bought late in the year 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. Poor recordkeeping may cause a revenue agent to disallow your deduction.
- Claims of Rental Losses: The IRS actively scrutinizes rental real-estate losses, especially those written off by taxpayers who say they are real-estate pros. 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; and, if you 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, you can write off losses without limitation. Beware if your W-2 forms or other non-real estate Schedule C businesses show lots of income and have not worked the necessary hours.
- R & D Credits: The IRS is on the lookout for taxpayers that fraudulently claim R&D credits and providers that push 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 activities which rise to the level of a process of experimentation.
- Day Trade 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, and traders’ profits are exempt from self-employment tax. To qualify as a trader, you must buy and sell securities frequently and look to make money on short-term swings in prices, continuously and not just for a couple of months. Agents are looking for filers who report trading losses or expenses on Schedule C but are actually investors.
- Marijuana Businesses: These entities are prohibited from claiming business write-offs, other than for the cost of the weed, even in the states where it’s legal, because a federal statute bars tax deductions for sellers of controlled substances that are illegal under federal law, like marijuana. The IRS is closely watching legal marijuana firms that take improper write-offs on their returns.
- Not Reporting 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 on their distributive share of the firm’s income. LLC and LP owners in law, medicine, consulting, accounting, architecture, and other professional service sectors are being eyed by IRS examiners!
- Last But Not Least – Cash: Businesses must report to the IRS on Form 8300 cash transactions they receive from customers in excess of $10,000. If your business deposits lots of cash into the bank at one time, be aware that banks must file reports on deposits in excess of $10,000 in a day or suspicious activities that appear to avoid the currency transaction rules like deposits $9,500 in cash one day and an additional $3,000 in cash two days later.
Reach out to us: Let us help you minimize the odds of the IRS giving your tax return a second look by avoiding these audit red flags. The IRS has been given $80 billion over the next 10 years for increased enforcement activities. Don’t tempt fate. Even if you are not self employed, audit flags include income you report (or don’t), the complexity of your return, the types and amounts of deductions or other tax breaks you claim, whether you’re engaged in a business, or whether you own foreign assets. Math errors could also draw an extra look from the IRS, but they usually don’t lead to a full-blown audit. Got questions? We have answers at CPA@fuoco.com or 855-542-7537.
