Audit Risks for Home Businesses
The IRS Pays Attention to Tax Returns When You Work at Home
When you operate a business out of your home, you may have a higher risk of being audited by the IRS.
Home based small businesses are one of the hot targets for potential tax audits from the Internal Revenue Service. Schedule C filers, (self-employment) are audited at a rate of 3%. Although this may not sound very high, after all, that means 97% of the people are not audited, it is three times as high as people filing taxes with W2s only.
There are additional flags the IRS looks for when determining which returns to audit:
- Home Office. A legitimate deduction as long as you follow the regulations set up by the IRS. It has a large potential for abuse and therefore it is a red flag for an IRS audit. Make sure you understand the rules for claiming a home office.
- Handwritten or sloppy returns. Most returns submitted are scanned and processed by computer. If the computer cannot interpret the information on your return, it is flagged for someone to manual review. Once this happens, they will look for additional errors. Use tax software or file electronically.
- Math errors. This is a red flag for the same reason as handwritten and sloppy returns are. Use tax programs or file electronically to catch any errors before you submit your return.
- Higher than average deductions. The IRS uses statistical data to determine the average deductions based on your income. If your deductions are higher than the average, a flag is raised for possible abuse of deductions. Make sure you have documentation. In addition, avoid using “miscellaneous” deductions unless absolutely necessary, instead be as specific as possible. You should also not round deductions, rather, use the exact figure. For example, deductions for office supplies will rarely come out to $3000.00. Instead add up your receipts and put the exact amount, even if it is $2998.00. For any unusual deductions, you can include documentation with your tax return.
- Meals. This again, has a high potential for abuse and therefore the IRS pays close attention to a deduction for meals and entertainment. Keep accurate records, including information on whom you were with and what business was discussed. Keeping a date book with information to coincide with your receipts will help you make the correct deduction.
- Unreported income. If you receive 1099s, the IRS receives a copy of each one. If your tax return does not reflect all the income that has been reported to the IRS, your return will be flagged and you will be sent a notice regarding the unreported income.
- A large drop or a large spike in income from last year. If you just started your business and your income has dropped a great deal from last year or if you are reporting a large increase in business, your return may be flagged for further review. Make sure you have documentation on your income fluctuation.
If at all possible, use a tax preparer. They will better understand why returns are flagged and how to properly use deductions, especially the home office deduction, to receive the most benefit without your return looking as if you are trying to get over on the government.
For more information:
10 Common Tax Audit Flags for Individuals
Tax Audit Flags for Small Business
References:
How Your Home Business Can Avoid a Tax Audit, Karen E. Klein, Business Week Magazine, 2007
Business Use of Your Home, Publication 587, Internal Revenue Service
Keeping Good Records, IRS Tax Tip 2008-08, Internal Revenue Service
