IRS Audit Red Flags – Part 2: Business

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

IRS Audit Red Flags – Part 1: Individual

It is time to prepare your 2016 income tax return, account for your income, and pay up. It would be nice if it were that simple, but it isn’t. Filing your return and paying the amount of tax due may not be the end of it. To keep taxpayers honest, the Internal Revenue Service (IRS) pulls a small percentage (less than 1%) of returns for audit.

Even if you are completely honest and forthcoming about income and deductions when you file your tax return, you do not want to be audited if you can help it; audits take your time, can cost you money if you need to hire representation, and are stressful.

According to the Internal Revenue Service, returns are not selected for audit at random; something about the return triggers an audit. Try to avoid the following audit red flags when filing your return.

Rounded numbers: When the numbers you enter end in zeros, the IRS suspects you are not using actual figures. Occasionally, you make have an actual number that ends in zeros. One such number will not likely flag your return, but a lot of rounded numbers will.

Unreported income: Any income you fail to report that has been reported to the Internal Revenue Service by a third party (1099 and W-2 income) automatically flags your return.

Sloppy or incomplete information: A tax return with math errors or that is incomplete will trigger a red flag. The IRS advises the use of tax preparation software to avoid this red flag.

Charitable donations: This deduction is often abused, so if you claim charitable donations in excess of the average for your income bracket, your return will be flagged.

Earnings of $100,000 or more: People with high incomes make it easy for the Internal Revenue Service to justify the expense of an audit. Consequently, those with incomes over $100,000 are 500 times more likely to be audited than those who earn less than that amount. You cannot avoid this red flag if you make over $100,000, so be sure to obtain and retain good documentation for any deductions or credits you claim.

Low income for your profession: The IRS has data on the average income in your locale for people in your particular profession. If you report income significantly lower than what the IRS would expect for someone in your profession, your return may be flagged to verify income.

Differences in Federal and State tax returns: When information on your Federal income tax return does not match the information you report on your State income tax return, red flags are triggered at both the Internal Revenue Service and your state revenue department. The IRS recommends using tax preparation software for your Federal and State returns to avoid this red flag.

Large swings in income: The Internal Revenue Service likes consistency. Consequently, large swings in income that cannot be explained by W-2 or 1099 reporting will cause your tax return to be flagged.

  • Job expenses: If you are a W-2 employee and take a job expense deduction, your return will be flagged. The IRS knows from experience that many more people take this deduction than can legitimately do so. They will assume that you may be one of those people.
  • Tax avoidance transactions: If the Internal Revenue Service discovers you have participated in tax avoidance transactions or if they suspect that you have, your return will be flagged for an audit.

    There is no way to absolutely avoid an audit of your federal income tax return. Nevertheless, the odds are in your favor that you will not be audited. You can improve those odds by avoiding audit red flags where you can and using tax preparation software to complete your return.

    Part 2 of IRS Audit Red Flags will address business returns.

    K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages

    All Debt Becomes a Drag on the Economy, Not Just Student Loans

    For the last couple of years, there has been a great hue and cry from economists, politicians, and certain special interest groups over the size of outstanding student loan debt and how it is a drag on the economy. At $1.2 trillion, student loan debt is second in size to mortgage debt. Although, outstanding credit card debt is close behind at $1 trillion. But I don’t hear anyone bemoaning mortgage or credit card debt as a drag on the economy. Why is student loan debt singled out as an impediment to economic growth?

    How debt repayment affects the economy

    It does not make sense because all debt becomes a drag on the economy once repayment begins. Initially, the use of credit is a boost to the economy. When credit is utilized, money that has not yet been earned is spent and purchases that would have occurred in the future are brought forward into the present. This gives the economy an artificial boost. But once repayment of debt begins, the money used for loan payments does not add to current economic growth because it is paying for past purchases.

    Student loan repayment is no worse than any other type of debt

    Student loan debt operates in the same way. When the borrowed money is spent, it boosts the economy: instructors and other employees at universities, trade schools, technical schools, and so forth get paid; textbooks, computers and other technology, supplies of all types, furnishings for dormitories, classrooms, and laboratories are purchased; maintenance services of all types are contracted; money is spent on transportation, printing, and advertising. All of which grows the economy. Then loan repayment begins and that money is no longer available for current spending.

    Economists and policymakers want to have their cake and eat it too

    Economists and policymakers want it both ways; they want to bring purchasing forward by expanding credit and still have economic growth when debt repayment begins. The only way to accomplish that is if there is a sufficient increase in incomes to offset loan payments or if additional credit is extended to those already in debt so they can continue to bring future purchases forward. The former has not occurred due to wage stagnation, and the latter is similar to a Ponzi scheme; eventually the chickens come home to roost when consumers become saturated with debt and credit can no longer be expanded, loan payments gobble up disposable income, and economic growth tanks.

    The fact that the Federal Reserve kept interest rates at near zero for over seven years during the recent economic recovery indicates that the expansion of consumer credit as a means to grow the economy may no longer be a viable strategy. Loan repayment of all kinds could be a drag on the economy for a very long time unless wage stagnation is overcome.

    K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages