Just being self-employed or the owner of a small business makes you more likely to be audited, but the following are additional Internal Revenue Service (IRS) audit red flags for small business/self-employed tax returns.
1. Home office deductions. This deduction is frequently abused: either the office in the home does not qualify as a home office under IRS rules or the expenses deducted for a legitimate home office are inflated. Taking this deduction is a huge red flag. Make sure you understand the rules that apply to the deduction and keep accurate records of expenses if you plan to take this deduction. Also, expect an audit.
2. Filing a Schedule C. The Schedule C is for computing the profit or loss from a sole proprietorship. Most home-based businesses operate as sole proprietors. The IRS knows from experience these businesses often do not keep accurate records of income and expenses and business and personal funds are often co-mingled, resulting in a less than accurate computation of income. The IRS suggests forming a separate business entity such as an LLC, S-Corp, or Corporation to conduct business to avoid this red flag. However, these separate business entities are much more complex in structure, accounting, and taxation than sole proprietorships. They are expensive to create and maintain and are not practical for very small businesses. Detailed record keeping, an understanding of basic accounting, and a separate business checking account will provide accurate information with which to complete the Schedule C and withstand an audit.
3. Entertainment deductions. This is another habitually abused deduction and the IRS knows it. Business entertainment deductions that are out of proportion to the size of the business will get flagged for an audit. Know the IRS rules for defining business entertainment, abide by them, document thoroughly, and keep accurate records if you take this deduction.
4. Losses reported from hobby instead of business venture. Many people turn hobbies into businesses. When does a hobby become a business? When it makes a profit. The tax code does not allow for the deduction of hobby expenses. If you report a loss for your business, this is a red flag for an audit. The IRS will want to determine if yours is a hobby or legitimate business.
5. Low income with large deductions. If your business return shows a low sales figure but your expenses are proportionately high, your return is likely to get flagged for an audit. There can be a number of legitimate reasons for a business to have low sales and high expenses: if it is a new business, if there was the loss of a large customer or contract, or if market conditions stifled sales. Of course, the IRS assumes the proportionately large expense figure contains illegitimate expenses, and they will want to verify the legitimacy of those expenses in an audit.
6. Claiming a loss on a business. If your business return shows a loss, it will be flagged for audit because a loss means no income to be taxed and no revenue for the government. There maybe legitimate reasons for a loss as noted in number five above, but the IRS will assume the books have been cooked. A loss can be created by underreporting sales or inflating expenses or both. The IRS will audit for legitimate expenses and possibly sales reporting.
A common thread running through these business return red flags is the reliance on proportion and common sense by the IRS. The IRS knows the standard profit margins and corresponding operating expense ratios for various classes of businesses. If your profit margins or expense ratios significantly vary from the standard, the IRS computers will flag your return for audit. Most small businesses make a profit after the first year or two; if your business is established and shows a loss, it makes the IRS suspicious and your return may be flagged for an audit.
I have filed a Schedule C for the last twenty-three years and have not been audited. Some years, I claimed entertainment and travel expenses and was not audited because those expense totals were reasonable given the type of business and the volume of sales. I have never taken a home office deduction because my home office would not qualify under IRS regulations. I have had several businesses over the years and all of them had expenses that were out of proportion to sales the first year or two due to start-up costs and the time it took to develop the business. None of those returns were audited. I keep detailed and accurate records and balance my business checking account against my business ledger each month. Every transaction is documented and accounted for. I am prepared should I ever get audited.
A red flag does not guarantee an audit and the odds are against the average individual or business being audited. Nevertheless, you may be audited, so practice due diligence in your personal and business affairs; document and keep good records; read and understand IRS regulations regarding the reporting of income, deductions, expenses, and any credits that pertain to you; get professional tax advice and preparation if necessary.
K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages