The IRS sends out thousands of notices every year to audit taxpayers. Receiving this type of notice can be terrifying for many people, even if they think they have done everything right when it comes to filing and paying their taxes. Audits are time-consuming, burdensome, and intimidating, so many taxpayers are interested in avoiding any potential IRS audit triggers. If you have received an IRS audit notice, consider visiting with the experienced tax attorneys at Damiens Law. We have helped many taxpayers address audits, and we may be able to help you as well. Call (662) 442-442-4423 to reach our Mississippi office or (901) 499-4466 to contact our Tennessee office.
How the IRS Chooses Returns to Audit
The IRS uses two main methods to audit tax returns. Neither method is good or bad, but it simply signifies different reasons the IRS may want to review a return.
- Screening and “Random” Selection. The IRS runs each tax return through a screening process. The screening process reviews each return against statistical formulas and algorithms to catch returns outside of certain “normal” levels. If a return is too far outside of the norm, it is manually reviewed to determine if an audit might be appropriate.
- Related Audits. The IRS will also often audit returns when a taxpayer is involved in a similar situation. For self-employed individuals, auditing a partner or co-owner might trigger an audit for all owners or partners.
The screening process has built-in evaluation categories. That means that certain aspects of a return are statistically more likely to trigger an audit compared to other tax return characteristics.
Self-Employment and IRS Audit Triggers
According to TRAC IRS, the overall audit rate for all taxpayers in 2022 (for the 2021 tax year) was 0.38%. Taxpayers that used a Schedule C to report income (most self-employed individuals) have a higher rate—between .08% and 1.6%, according to 2019 figures.
Being self-employed alone is not necessarily an audit trigger. However, self-employment often involves several IRS audit triggers that individuals might want to consider.
Meals, Travel, and Entertainment Expenses
Self-employed individuals can take a wide variety of business expenses off of their taxable income through Schedule C. One of those categories of costs is for meals, travel, and entertainment.
The IRS qualifies that taxpayers cannot deduct expenses that are “lavish or extravagant,” but it does not define what kind of dollar limit would be considered lavish. As a result, higher dollar values in this category might be a sign that the taxpayer is deducting too much.
The IRS compares travel and meal deductions to what other taxpayers in the same or similar industries have claimed. If the expenses seem too high for that particular type of business, that can cause the IRS to request a more in-depth look at those expenses. Taxpayers will need to present receipts and other records to properly support these expenses. These records include receipts for the expense itself and evidence of the business-related reason that the travel or meal expense occurred.
Large Gross Income
The IRS may be interested in a return when a self-employed individual reports a large amount of earned income. In general, if a sole proprietor has $100,000 or more income, then they have a higher audit risk.
Of course, higher-income individuals should not try to make less money or report that they have made less money. Instead, they may just need to be extra cautious when it comes to keeping records. Having the proper documentation about every item of income and every expense will be extremely helpful in the event of an audit. Damiens Law can often work with taxpayers to ensure they keep the documents they need for an audit. We can also step in to assist with responding to information requests for audits as well.
Lower Income: “Hobby” Businesses
In some situations, taxpayers attempt to turn their hobby into a business for tax purposes. By doing this, they can take hobby expenses and report a loss on their tax return. Reporting a loss, in turn, often allows them to pay less in taxes on other sources of income, including W2 wages and some investments.
However, using a hobby as a business is not a legally permitted method to file taxes. If a business reports losses for several years, it can become an IRS audit trigger. Not every company will make money each year, but many years of losses can signify that the venture is more of a hobby than a legitimate business.
To take a business loss, a taxpayer must run the activity in a business-like manner. The taxpayer must also have a reasonable expectation of making a profit over time, even if that profit is not immediate. In general, if the activity generates a profit every three out of five years, then the law will likely consider the activity a business venture.
Claiming a Home Office Deduction
Many small businesses (and some very large companies) claim home office deductions. With the rise of working from home because of COVID-19, home office deductions are becoming even more common. The home office deduction can be very valuable for some taxpayers because it allows them to deduct a portion of virtually every expense that affects their home office, including:
- Real estate taxes
- Internet service
- Rent or mortgage interest
Taxpayers also have the option to take a standard, simplified option for the deduction. The simplified method allows taxpayers to claim $5 per square foot, up to $1,500.
In some situations, taxpayers try to stretch the home office deduction a bit too far. When a home office deduction is large, that can be an audit trigger. Specifically, the IRS will not only look at the reported expenses but also often look at the reported square footage used for the home office. If the square footage is high, especially compared to the size of the home, that can be a red flag. Further, taking the home office deduction at all in some industries can cause the IRS some concern.
Business Use of a Vehicle
Business owners can use and depreciate a vehicle when they use it for business. As part of claiming depreciation, the business owner must state the percentage of use of the vehicle for business and personal reasons. Small businesses rarely use vehicles for 100% business use. As a result, a vehicle that has 100% business use on a tax return is likely a red flag for the IRS. Large trucks and heavy SUVs seem to be more of a trigger compared to other vehicles, likely simply because of the size of the potential deduction.
Large Cash Transactions
Some small businesses deal in large cash transactions. Of course, if a client wants to pay in cash, most self-employed individuals will not turn down that type of payment. Nonetheless, large transactions ($10,000 or above) might trigger a suspicious activity report from a bank or other financial institution. These required reports provide specific information about any large transaction, which is then shared with the IRS.
Claiming Rental Losses
Some small businesses specifically hold and manage real estate, and that is their only function. Whether rental income is a main business or a side hustle, rental losses can be an IRS audit trigger.
Many rental activities are passive, so those losses cannot be deducted against active income-generating activities. However, if a taxpayer is an active participant in their real estate venture, they deduct up to $25,000 in losses against other income. That allowance phases out for higher income earners, with a complete prohibition on the deduction if a taxpayer’s AGI is over $150,000.
The other exception to the passive income rule is when the taxpayer is considered a real estate professional—they spend at least half of their working hours on real estate or 750 hours per year. However, the IRS will often audit those who claim they are real estate professionals when they claim losses offset other income. The IRS will want to see hours logged to verify minimum requirements.
Failure to Pay Self-Employment Income Taxes
Self-employed individuals must also pay self-employment taxes. Taxpayers use Schedule SE to figure and report self-employment tax. Self-employment tax covers required payments for Social Security and Medicare.
Some self-employed individuals do not correctly calculate their income for professional services to determine their self-employment tax. Specifically, members of limited liability companies (LLCs) and limited partnerships (LPs) must still report their active participation in the venture as self-employment income and pay separate self-employment taxes. Classifying yourself as an investor in an LLC or LP rather than an active, self-employed person can be a red flag for the IRS and result in an audit.
Learn More About Self-Employment Reporting and IRS Audits
The dedicated and experienced tax attorneys at Damiens Law can often help self-employed individuals retain the correct documents to address an IRS audit. Our legal team is also able to review records and returns and provide insight into which items might be IRS audit triggers. Learn more about our legal services by contacting our office. Contact our Mississippi office at (601) 957-9672 or our Tennessee office at (901) 499-4466 today to learn more.