I’ve had clients tell me “The IRS will never audit me”. This may be true. It is very possible you can go through your entire life and never be audited. That being said, the IRS looks at self-employed persons with a closer eye of scrutiny than a regularly employed person. It just makes sense. There are many areas that a self-employed person can try to be creative on their tax returns (the Schedule C), thus more room for the IRS to find fault, or even worse, fraud. To reduce your chance of being audited don’t raise any red flags!
Red Flags That Could Possibly Trigger an IRS audit
1. Unreported or Under Reported Income:
You must report all income. Most self employed persons will receive form 1099MISC for work they have done for another company. All of these 1099’s must be accounted for on the tax return. Also, any income received that is not covered on a 1099, such as work performed for a private party, must be included in your income. Remember, if you were to be audited, the IRS will look at all bank records, and how you live. So if you claim 50K in income, but live in a 500K home, this will only make them dig deeper to see where the money came from to afford you this lifestyle.
2. High Mileage Claimed
Mileage must be for business purposes, and make sense. If you own a landscaping company, use trucks, and all of your jobs were within a 20 mile radius of your office location, it may not be wise to claim 20,000 miles on your vintage Camaro as a business expense. In addition, the make and model of vehicle is listed on your tax return, so the IRS knows this is unrealistic. Note: Mileage must also be recorded on a mileage log (there are many apps that can help with this.)
3. Disproportionate Business Expenses
Business expenses need to be in proportion to the income earned. If you have an unusually high expense, then claim it. But make sure you have all receipts and clear records to show the expense and the payment for it.
4. Home Office Deduction
I am a big believer in the home office deduction. People are either afraid to claim it, because it can be an audit trigger, or they over-claim it. Over-claiming the deduction would be saying the 10×10 room you use for your office is really 20×20, thus doubling your deduction. Again, the deduction should be reasonable. The caveat on the home office is that the area used must be exclusively used for business. If you have a computer set up in your family room where you also watch television and play video games, this is not exclusive use.
5. Charitable Giving
I am adding this to the list even though it is not specific to just the self-employed person. This is a big red flag when the number is high or disproportionate to your income.
Two real life scenarios:
- I had (notice I said had) a tax client who sent me their tax data to prepare a tax return. On one page it said charitable-$8454.00. Now, this was the first year in doing this person’s return, so I called and asked her for the name of the church or organization that she gave to, as well as documentation for the deduction. She said “ I don’t really give any money to anyone-just put it on the return.” Needless to say, I did not put it on the return, and she is no longer a client. This would have been blatant fraud for her and me as the preparer.
- Another self-employed client, said “I gave my church $28,645.00. (His gross income was $286,450.00). I questioned him, and he produced a statement from his church showing the contribution. He said “I tithe 10% of my income.” Even though this seems high, the contribution was put on his tax return with no concern, as it is fully documented and truthful.
Think About It
We are in business to make money. In a perfect world, we show a net profit every year. Every self-employed person wants to reduce his or her net profit to pay less taxes. Under-reporting income or inflating the business expenses is not the way to do it. Again, it has to make sense. If you own a manufacturing business and you show your income at 100K and Cost of Goods Sold at 50K, so far so good, you have a Gross Profit of 50K. If you then show operating expenses that exceed the 50K, now we are running at a loss. So the IRS wonders…how did you pay your mortgage?…or eat?
No one wants to be audited by the IRS, Ever.
Tax law may be complex, but keep in mind the simplicity of common sense and reporting the real numbers. If the books for the company are accurate, then they can be backed up by bank statements, credit card statements and cash receipts. These numbers then flow to the tax return, and, as I like to say, “it is what it is”.
You can be chosen for an audit due to a trigger, or it also can be random. That is why it is so important to always have your monetary ducks in a row (both business and personal).
If you have all of the data to back up your income and deductions, the audit process will be much easier and you will come out far better in the end. No one wants to be audited, but well kept records and accurate reporting will go a long way to sleeping well at night…even during an audit.
Disclaimer: The contents of this article are not meant to be tax advice, legal advice or personal therapy