While few people find the annual inevitability of filing a tax return to be a cause for celebration, tax preparation can seem like a pleasure compared to the pain that comes from opening an IRS audit notice. An audit is never good news, but fortunately it is avoidable for most of us. In fact, the IRS is happy to share with American taxpayers the items that are most likely to lead to additional scrutiny. However, if you’d like to guarantee closer inspection from the taxman, simply get “creative” in the following key areas:
The Hobby Loss
Some businesses lose money. The IRS understands that this is a sad fact of life, but the government will carefully scrutinize a business that consistently loses money year after year. Is it really a business or is it an expensive hobby? If you’ve turned a profit in three of the last five years, the IRS is likely to consider this a legitimate business. If your business has not met that threshold, be prepared to make a convincing case for your heartfelt interest in running this business in the black.
It should come as no surprise that the IRS likes statistics. It has its own ideas about the deductions that are typical for a given level of income. If you fall too far outside the conventional limits, it raises red flags. For some categories, like the mortgage interest deduction, the IRS receives independent verification. For others, like charitable deductions, there is no such confirmation. If the IRS has questions related to charitable deductions, be prepared to provide complete written records. Several computer software programs like TurboTax or the Turbo Tax Military edition for those in the armed forces are available to help you figure deductions for charitable contributions.. Don’t forget to get a receipt from the charity of any donated goods.
The Home Office
Although many people work at home and require a home office, this deduction oftentimes results in extra IRS attention. The rules related to home offices are complex. Is your home the principal place of business? Do you have another office? Is your home office used exclusively for business? If you occasionally do some paperwork at the kitchen table, be prepared for a hefty fine. Even if you qualify, resist the temptation to exaggerate the office’s size in relation to the rest of the home. The IRS uses a standard ratio to determine the extent to which home expenses can be attributed to the business.
The Schedule C Problem
The IRS takes special interest in Schedule C, the home of business and self-employment income, because it estimates that it accounts for more than 60 percent of all under-reported income. Schedule C income can come from several sources, but some of it is likely to be reported on Form 1099, and the IRS gets a copy of that form. The income shown on Form 1099 should match the income reported on your return.
The other side of the Schedule C ledger can also cause problems. Overstated business expenses or deducting expenses that have only a tenuous connection to your business is an open invitation for further scrutiny. If you are convinced that your expenses are legitimate, be sure that you have written records that back this up.
Business Use of Your Car
There are many perfectly legitimate ways to use your car in business, but the IRS has some very definite ideas about what you can deduct. An incidental business purpose is not enough to make a trip deductible. Commuting doesn’t count, even if you had to stop off at the printer to pick up copies of your latest proposal. If you drove those proposals from your office to your client, however, that makes for a business purpose. In any event, written records are crucial, and they should spell out locations, mileage and a legitimate business reason for any trip you hope to deduct.
An IRS audit does not have to be the end of the world. In its simplest form, it may consist of a letter asking for additional information or provide an invoice for additional taxes owed. In almost all cases, the taxpayer has the opportunity to either agree with the IRS and make the changes, or disagree and enter an appeal. If you want give yourself the best chance of avoiding contact with the IRS after you’ve submitted your return, pay close attention to the topics that tend to catch the taxman’s skeptical eye.