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Watch Out for the IRS Audit Red Flags

Q: Is it true that I stand a greater chance of being audited by the IRS because I’m self-employed? Here’s the response by Joy Taylor, editor of The Kiplinger Tax Letter:

A: Being in business for yourself can be exciting, lucrative – and a great way to draw the attention of the IRS’s audit division. Short on personnel and funding, the IRS has audited significantly less than 1% of all individual returns in recent years. But if you file a Schedule C to report profit or loss from a business, your odds of drawing additional IRS scrutiny go up.

Schedule C is a treasure trove of tax deductions for self-employed people. And it’s also a gold mine for IRS agents, who know from experience that self-employed people sometimes claim excessive deductions and don’t report all their income. The IRS looks at both higher-grossing sole proprietorships and smaller ones.

Special scrutiny is given to cash-intensive businesses (taxis, car washes, bars, hair salons, restaurants and the like), people with freelance service gigs through the sharing economy, 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 reported on the return, such as wages or investment income).

Here are a handful of scenarios that could attract unwanted IRS attention.

Big deductions for meals and entertainment. 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.

Making a lot of money. Your audit odds increase dramatically as your income goes up. Sole proprietors reporting at least $100,000 of gross receipts on Schedule C have a higher audit risk. And millionaires face the most audit heat.

Not making enough money. Not every business ends up in the black every year, but too many years of losses can make the IRS think you’re not really taking your business seriously enough – that it’s just a hobby.

Claiming the home office deduction. 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. Alternatively, you have a simplified option for claiming this deduction: The write-off can be based on a standard rate of $5 per square foot of space used for business, with a maximum deduction of $1,500.

To take advantage of this tax benefit, you must use the space exclusively and regularly as your principal place of business. That makes it difficult to successfully claim a guest bedroom or children’s playroom as a home office, even if you also use the space to do your work.

Claiming 100% business use of a vehicle. When you depreciate a car, you have to list on Form 4562 the percentage of its use during the year that was for business. Claiming 100% business use of an automobile is red meat for IRS agents. They know it’s rare for someone to actually use a vehicle 100% of the time for business, especially if no other vehicle is available for personal use.

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