10 Red Flag Filing Mistakes to Avoid Triggering an IRS Audit as a Self-Employed Business Owner

Posted September 18, 2023

There are many benefits to being self-employed, sole proprietor or a small business owner, but there are also risks (even if the chances are small) one of those is making a filing mistake that triggers an IRS audit. So let’s go over some of the most common IRS audit red flags to avoid, so that they don’t scrutinize your next tax filing return. According to an article on the subject in Kiplinger last January of 2023, “The IRS has audited significantly less than 1% of all individual returns in recent years, so most taxpayers can rest easy. But if you file a Schedule C to report profit or loss from a business, your odds of drawing additional IRS scrutiny go up.”

For example, the Schedule C Form 1040, offers abundant tax write-offs for the self-employed, but it can also invite IRS scrutiny for potential deduction abuse or unreported income. IRS agents closely examine returns from high-earning sole proprietors as well as smaller businesses. Cash-heavy companies, highly profitable enterprises, and small-business owners claiming large net losses on Schedule C may trigger an audit, especially if those losses substantially offset other income like wages or investment earnings. While Schedule C deductions provide tax savings for the self-employed, improper claims can flag returns for IRS examination.

For a little background, Schedule C is an IRS form utilized to document annual business revenue and expenditures. It is completed by sole proprietors, freelancers, gig workers, independent contractors, and other self-employed individuals. The goal of Schedule C is to supply a precise record of a business’s earnings and costs to properly compute any tax obligations. By reporting detailed financial information, Schedule C allows self-employed taxpayers to account for business income and deductions when filing their personal returns.

If you remember last year President Joe Biden passed a bill called the Inflation Reduction Act, passed last year, gives the IRS $80 billion in extra funds over 10 years, with a large portion of the funding to be used by the IRS for increased enforcement activities and collection measures. While the full impact of the IRS’s $80 billion budget increase on tax enforcement likely won’t be apparent for a couple of years, taxpayers should still prepare for the potential of increased audits. Even though your 2022 return filed this year may not get examined right away, it could still face IRS scrutiny in 2024 or early 2025 as more resources are allocated. So remaining audit-ready is prudent despite the lag time between filing and selection, as the massive IRS funding aims to ramp up challenges of suspect returns down the road. It’s better to be informed and proactive in steps to minimize your chances of this happening to you. Here are a few red flag audit filing mistakes to be aware of to save you money and headaches down the road.

Taking Excessively Large Deduction on Schedule C

Returns reporting substantial Schedule C losses raise red flags, particularly if the deductions creating those losses seem disproportionately large. In an audit, the IRS closely verifies supporting records for sizable write-offs.

Revenue agents also scrutinize if deductions have a legitimate business purpose and aren’t disguising personal costs. One of the most common triggers for Schedule C audits is when the IRS suspects you failed to report all income from self-employment.

To avoid issues, maintain a separate business bank account and thorough documentation for all expenses. Proper substantiation of outsized deductions is essential, as is confirming they qualify as valid business expenditures. With Schedule C inviting increased IRS attention, taxpayers claiming major losses should expect their documentation and business purpose to draw scrutiny.

Businesses That Report Small Losses

Businesses that report losses are typically targets for the IRS because an audit has a greater potential of producing income if incorrect. If you are a startup it’s not uncommon to have little revenue or losses in the the first year or two.

Basically, if the IRS looks at your return and thinks that you should have paid more in tax, it may follow up to try to get more money.

Writing Off a Loss From a Hobby

Recurring losses on Schedule C can raise suspicions that an activity is a hobby rather than a serious business pursuit. The IRS targets returns offsetting other income like wages or investment earnings with substantial losses from potentially hobby-like ventures year after year. Though the hobby loss rules are frequently litigated, the IRS usually prevails or settles unfavorable cases.

An HRBlock article states that the IRS usually considers your hobby a business if you’ve made a profit for three of the past five years. Otherwise, you have to establish a profit motive. You will determine your profit motive based on factors like:

If you carry on the activity like a business
Your expertise
Time and effort you spend on the activity
Your success in carrying on other similar or dissimilar activities
Your history of income or losses for the activity
Occasional profits, if any, that you earn
Your overall financial status
If the activity has elements of personal recreation

To qualify for loss deductions, an activity must be conducted in a business-like manner with a profit motive. If an endeavor is profitable in 3 of 5 consecutive years (or 2 of 7 years for horse breeding), the law assumes it is a business barring contrary evidence.

When this safe harbor is not met, the facts and circumstances determine whether an activity is a hobby or business. In an audit, the IRS requires proof of a legitimate profit-seeking enterprise, not a hobby. Taxpayers claiming losses should retain documentation to demonstrate business practices and expenses. While some losses are expected, recurring Schedule C deficits invite IRS scrutiny of a taxpayer’s profit objectives.

Inflating The Home Office Deduction

Small business owners can deduct on Schedule C a percentage of the 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. So to meet the eligibility requirements for taking a home office deduction, a space needs to be created that is “exclusively used” (and is the principal location) to meet with clients, patients or customers in the normal course of business, or is where management or administrative functions (for example billings, maintaining books and records, ordering supplies, making calls, scheduling appointments etc.) are conducted.

Your audit risk increases if the deduction is taken on a return that reports a Schedule C loss and/or shows income from wages.

Taking Large Deductions for Meals, Travel and Entertainment

Is it business or pleasure? 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.

To qualify for meal or entertainment deductions, you must keep detailed records that document the amount, place, people attending, business purpose, and nature of the discussion or meeting.

Without proper record-keeping and documentation, your deduction could be lost.

Claiming 100% Business Use of a Vehicle

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

The IRS also targets heavy SUVs and large trucks used for business, especially those bought late in the year. That’s because these vehicles are eligible for favorable depreciation and expensing write-offs.

Make sure you keep detailed mileage logs and precise calendar entries for the purpose of every road trip. Not keeping thorough records makes it easy for a revenue agent to disallow your deduction.

Claiming Rental Losses

Real estate businesses, particularly side ventures, invite IRS scrutiny of rental losses. Though passive loss rules normally restrict deducting rental real estate deficits, two key exceptions exist. Taxpayers actively participating in their property’s rental can deduct up to $25,000 against other income, phasing out above $100,000 AGI and eliminating entirely over $150,000.

Additionally, real estate professionals spending over 50% of work hours and 750+ annual hours materially participating in real estate can fully deduct losses.

The IRS examines returns of filers claiming real estate professional status while reporting substantial W-2 or non-real estate Schedule C income. Agents verify these taxpayers worked the required hours, especially landlords with non-real estate day jobs. With rental real estate losses attracting attention, taxpayers should document material participation and hours to justify tax deductions.

Taking the Research and Development Credit

The research and development (R&D) credit is one of the most popular business tax breaks especially for biotech, and technology focused startups, but it’s also one that IRS agents have found is prime for abuse. The IRS is on the lookout for taxpayers who fraudulently claim R&D credits and promoters who aggressively market R&D credit schemes. These promoters are pushing certain businesses to claim the credit for routine day-to-day activities and to overinflate wages and expenses in the calculation of the credit.

To be eligible for the credit, a business must conduct qualified research—that is, its research activities must rise to the level of a process of experimentation. Among the activities that aren’t credit-eligible: are customer-funded research, adaptation of an existing product or business, research after commercial production, and activities in which there is no uncertainty about the potential for a desired result.

Operating a Cannabis Business

Marijuana industry businesses have an income tax problem. Its still not Federally legal. They’re prohibited from claiming business write-offs, other than for the cost of the cannabis products, even in the ever-growing number of states where it’s legal to sell, grow and use marijuana for medical or other purposes. That’s because a federal statute bars tax deductions for sellers of controlled substances that are illegal under federal law, such as marijuana.

The IRS is eyeing legal marijuana firms that take improper write-offs on their returns. Agents come in and disallow deductions on audit, and courts consistently side with the IRS on this issue. The IRS can also use third-party summons to state agencies, etc., to seek information in circumstances where taxpayers have refused to comply with document requests from revenue agents during an audit.

Failing to Report Certain Professional Earnings as Self-Employment Income

The IRS is targeting limited partners (LPs) and limited liability company (LLC) members in professional services who don’t pay self-employment tax on distributive income shares. An ongoing audit campaign examines when LPs and LLC members in fields like law, medicine, consulting, accounting, and architecture owe self-employment tax.

A 2017 Tax Court ruling held LLC members actively involved in management and operations were not mere investors but liable for self-employment taxes. With successful audits in recent years, the IRS will continue scrutinizing LP and LLC owners who don’t file Schedule SE, especially those providing professional services. When partnership distributions represent compensation for services, IRS agents contend self-employment taxes apply regardless of entity structure.

So Here are a Few Ways to AVOID Getting an IRS Audit 📝

File Your Tax Return on Time
The penalty for not filing is worse than the penalty for not paying.
The changes for an audit for not filing are higher than not paying
Beware of industry averages (expenses)
Keep organized records and (bookkeeping)
Attach the proper statements and forms to your tax returns
Avoid Schedule C (S-Corps are 15x less likely to get audited than schedule C)
Issue 1099’s
File payroll reports (W-2’s)
Avoid Claiming False Dependents
Avoid round numbers
Don’t inflate home office deduction
Avoid excessive travel and dining
Do not ignore IRS letters!

Conclusion

In conclusion, the tips above illustrate a few strategies to potentially decrease your audit risk, though no foolproof methods exist. And this was not a full list of potential red-flags, an article by the W Tax Group, lists out a few other types of issues. Taxpayers can only take certain steps to improve the odds, as audits remain a possibility for any return. While audits can happen to anyone, thoughtful preparation and working with professionals can help navigate the process smoothly.