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Self-Employed? Avoid These Audit Red Flags on Your Tax Return

Mar. 1, 2016 Kiplinger

Being in business for yourself can be exciting, lucrative — and a great way to get in the sights of the Internal Revenue Service’s audit division. Short on personnel and funding, the IRS audited only 0.84% of all individual returns in 2015. But file a Schedule C to report profit or loss from a business, and your odds of drawing additional IRS scrutiny go up.

Schedule C is a treasure trove of tax deductions for self-employeds. And it’s also a gold mine for IRS agents, who know from experience that self-employeds sometimes claim excessive deductions and don’t report all of 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) as well as to small-business owners whose Schedule Cs report a substantial net loss.

Big Deductions for Meals, Travel and Entertainment
Is it business or pleasure? A large write-off for restaurant tabs and hotel stays will set off alarm bells, especially if the amount seems too high for the business or profession.

Agents are on the lookout for personal meals or claims that don’t satisfy the strict substantiation rules. To qualify for meal or entertainment deductions, you must keep detailed records that document the amount, the place, the people attending, the business purpose and the nature of the discussion or meeting. Also, you must keep receipts for expenditures over $75 or for any expense for lodging while traveling away from home. Without proper documentation, your deduction is toast.

Making a Lot of Money
Your audit odds increase dramatically as your business income goes up. In 2014, the IRS examined about 1 percent of small-business filers whose total gross receipts were under $25,000. Compare this to the 2.1% audit rate for businesses with incomes above $200,000. Millionaires face the most audit heat. Last year, 9.55% of taxpayers with incomes of at least $1 million got audited by the IRS.

We’re not saying you should try to make less money. Just understand that the more income shown on your return, the more likely it is that you’ll be hearing from the IRS.

Not Making Enough Money
Not every business comes 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.

To be eligible to deduct a loss, you must run the operation in a business-like manner and have a reasonable expectation of making a profit. If your activity generates profit three out of every five years (or two out of seven years for horse breeding), the law presumes that you’re in business to make a profit. Otherwise, be prepared to answer some tough questions and be sure to keep supporting documents for all expenses.

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