What Raises Red Flags for IRS Audit??

You are much more likely to be audited if you’re self-employed. That is, if you file Schedule C with your 1040, you are more likely to be selected for an audit.

The honor of calling yourself a small business owner comes with strings attached. It’s better to be your own boss, but it does make the IRS look more closely at you.

The truth is, most taxpayers needn’t worry. The IRS audits fewer than 1 percent of all individual returns.

Schedule C presents many opportunities for deductions. IRS agents know self-employed filers sometimes are liberal with the deductions and conservative with the income reported.

The IRS pays attention to both big and small proprietorships. Cash businesses tend to be a target. So do very profitable firms or those with large losses to offset a salaried income or investments.

The amount of tax cheating the IRS can catch depends, to some degree, on how much money Congress gives the IRS to catch tax cheats. A greater IRS budget means more IRS agents, and more agents usually means more audits.

If the amount of money the IRS is allowed to spend on enforcement decreases, you can probably expect the pressure to abate or shift.

No one can say for sure whether you’re going to be audited, but if you’re self-employed there are 10 red flags that may raise the chances you will be.

Big Losses on Schedule C

Deductions, losses or credits that are out of line with your income may get an IRS reviewer’s attention. The same is true for Schedule C deductions.

Big losses on Schedule C can get the IRS’s attention, particularly if you also have a ton of deductions. The IRS expects you to have plenty of documentation to back up big Schedule C deductions if you get audited. If you don’t have these records, large write-offs may not survive an audit.

In an audit, they’ll check that each write-off has a legitimate business purpose. They’ll also look for any personal expenses that may be masquerading as business expenses.

How to cut your risks: Open a separate account for your business, and make sure you have records supporting any Schedule C deductions.

The more you make, the greater the chance you will be audited.

For a time, the agency got bad publicity for concentrating on lower-income earners who often received refundable tax credits. Big fish, mostly ignored during recent years, are now back in the IRS’s sights.

The IRS also has said more tax enforcement and collection efforts will be aimed at wealthy individuals and “pass-through” entities like limited liability companies and partnerships.

The IRS says there won’t be more audits of middle-income taxpayers, but that depends on how they define “middle income” and how they measure it.

The IRS measures this against an earlier year when the agency had a low rate of audits, which is great for taxpayers.

By comparison, fewer than 1 percent of individual income tax returns were audited during each of the past few years.

Don’t misunderstand, this doesn’t mean you should try to make less money. But it does mean you should make sure you’re prepared for the fact that you’ll probably have more IRS contact the more you earn.

Businesses go through ups and downs, but if you show years of losses, the IRS may decide it’s really a hobby.

And if you have a business that repeatedly shows a loss that you use to offset your wage and investment income, the IRS may come calling. Hobby losses are a common cause of tax litigation before the U.S. Tax Court. And sometimes, the taxpayer prevails.

In order to claim a loss, you must operate the activity like a business, with a reasonable expectation of making a profit.

There’s a rule that if you have a profit in three of every five years, the activity will be presumed to be a business unless the IRS proves otherwise. Horse breeding is presumed to be a business if there is a profit in two of every seven years.

If you don’t qualify for one of the safe harbors, then whether or not an activity is a hobby or a business will be determined based on your specific facts and circumstances. In other words, you will need to fight harder for a loss to be deductible for a business that doesn’t fall within a safe harbor.

In an audit, you’ll have to prove that the business isn’t a hobby. And that means keeping a record of every receipt for expenses.

To calculate depreciation for a car, you’re required to report the percentage of use for business purposes on Form 4562. Claiming 100 percent business use looks fishy, especially if you don’t have another car.

Heavy SUVs and large trucks bought toward the end of the calendar year are a frequent target, too. That’s because you get huge depreciation and expensing breaks.

Keep a log of the mileage you drive for business and keep a diary of business trips. Otherwise, it’s easy for an IRS agent to come up with a reason to disallow it.

The trading business is a tax-friendly one. Traders get to deduct their expenses on Schedule C. They don’t pay self-employment tax. If they file a section 475(f) election, their trading losses turn ordinary, avoiding the $3,000 capital loss limitation.

A trader is one who buys and sells in quick succession in hopes of short-term swings in price, all year long. An investor holds longer, often for dividends or long-term appreciation in stock prices. Investors don’t trade as often.

Lots of small-business filers use Schedule C to report losses from trader transactions. But many of them may actually be investors who don’t qualify for the favorable tax rules for traders. And now the IRS knows which returns to pick to ensure filers are claiming their proper status.

Real Estate Pro

You might also be able to write off rental real estate losses, but the IRS will look closely at your tax return if you try to claim that you’re in the real estate business and deduct all your rental losses.

Tax law generally prohibits claiming passive losses from rental real estate. That is, unless you qualify for one of two exceptions.

One exception is that you can deduct up to $25,000 a year in losses against other income if you actively participate in renting out the property.

The catch is that this allowance begins to phase out once you have AGI of more than $100,000 and is gone entirely once you reach $150,000.

Another exception applies if you are a real estate pro. The exception allows you to deduct all of your rental real estate losses without limit. Real estate professionals include real estate developers, brokers, landlords and agents. In order to qualify for the real estate pro exception, you need to meet strict time requirements.

Your chances of being audited also go up if you are a pro with losses on rental real estate that you use to offset other income, in particular, wage or investment income. IRS agents focus on the hours and tend to be skeptical that a landlord who has a full-time job outside real estate would have the time to be a real estate pro.

Business Tax Breaks

One of the most popular business tax breaks - the research and development credit - is also one of the most abused, agents say.

IRS examiners scour returns for false claims, and they pay particular attention to pushy promoters who encourage clients to claim a tax credit for routine work and inflated wages and expenses.

To qualify for the R&D credit, you must be doing qualified research. That means a process of experimentation. Also, if you have work that does not involve uncertainty about reaching the intended result, you can not claim it.

Even though marijuana is legal in some states, owners of dispensaries can’t deduct normal business expenses because of a federal law barring deductions for illegal drug-trafficking. Marijuana is illegal under federal law. They can, though, deduct the cost of the product.

The IRS will be combing returns to make sure weed shop owners don’t cheat. If they do, the IRS is likely to audit them. And then the IRS will disallow the normal expenses on audit. Courts have upheld the IRS’s position. If owners refuse to hand over books in an audit, the IRS may use third-party summonses to get information directly from state agencies.

A favorable change in federal pot law would open the deduction door. Whether or when that would happen, though, is open to question. In the meantime, owners should expect the current law to remain in effect and the IRS to keep watching.

Got a big write-off for restaurant meals and hotels? If you take deductions for lavish restaurants and hotel expenses, you are more likely to be audited. Agents look for write-offs that seem high for the type of business.

Record-keeping is crucial. You must keep a diary that lists who you were with, where you ate and what business you discussed. If you don’t have the record of expenses, then no deduction.

If you’re self-employed, you get to write off a proportion of your rent, property taxes, utilities, phone and insurance on Schedule C. A great perk, but watch out that you’re not claiming more than you should be.

The simpler option is to take a deduction of $5 per square foot of home office space, up to a maximum $1,500 write-off.

The rules state that the home office has to be your primary place of business, used regularly and exclusively for work.

The guest bedroom/play room that you also use for work is hard to pass off as a home office.

You don’t take write-offs for a family room that doubles as an office at night, because you have to use the area exclusively for business.

Self-employed folks who claim a home office might be asked to prove it. The IRS has often won court fights with taxpayers over questionable home office claims. Did you claim a home office deduction? Then, the odds of an audit increase, particularly if you had a loss or wage income.

The home office deduction is only for the self-employed. Employees can’t take it, even if the employer closed the office and sent everyone home.