There is a 50% chance you will be audited at least once in your lifetime. If you are self-employed, your chances of an audit are considerably higher. The IRS has identified small-business owners as the largest source of uncollected tax money. Burdened with this “tax evader” stigma, these taxpayers are the most highly targeted. Here are four common red flags for the self-employed that can trigger IRS scrutiny:
Major Income Fluctuations
If you report a sudden plunge in revenue, the IRS may suspect you are under reporting your income. Their audit team tracks historical data so they may want to know the reason for any major changes in your income compared to previous years. Of course, legit circumstances like economic recessions result in years of slowed business; and there is nothing illegal about that. Just make sure to keep good records to backup your income for your own safety if an audit arises.
Home Office Deduction
Many taxpayers have milked the home office deduction but this has not gone unnoticed by the IRS. Working from home allows you to deduct a portion of your rent, utilities, insurance, and home repairs. However, the space that you claim as your home office must be used exclusively for business. The deduction is generally based on the percentage of your home that is entirely devoted to business use. In general, the larger the space you claim as a home office, the larger your chances of an audit, especially if you make very little income.
Excessive Meals & Entertainment Deduction
You can deduct 50% of the cost of meals at business meetings as long as the primary purpose of the meeting is for your business. This includes meetings with your employees, partners, and/or prospective clients. You can also deduct 50% of the cost of meals you provide to your employees on the premises, for example, at a company cafeteria. Unfortunately, this is another commonly abused deduction, as some business owners are tempted to run the company card every time they eat out, whether business related or not. Keep in mind the IRS has automatic processes that compare the numbers you report on your tax return to statistical norms. If any of your deductions are disproportionately large compared to your income or compared to the industry average, your tax return may trigger a flag for audit.
Earning over $200k
These large scale audits are the most rewarding for the IRS because the larger the business, the more complex the tax return, the more likely it is to contain errors, and the larger the tax revenue recovery. If your income exceeds the $200k benchmark, you are four times more likely to be audited.
Even if you don’t fall into the above categories, you may be audited purely by bad luck. The IRS audits a good portion of taxpayers at random, like pulling numbers out of a hat. Being proactive and keeping a clean paper trail to justify your business income and expenses can save you time and stress if that Audit Notice is delivered.