Today, we’re going to be discussing how to minimize your audit risk. We’re going to identify the audit triggers and the red flags. This article is really catered for the self-employed people. This is sole proprietorships, single member LLCs, but it’s also applicable to business owners. Some of these pieces of information and advice might seem blatantly obvious. However, I feel like I need to write it because I see clients bringing these types of returns in all the time that get audited. And it’s clearly identifiable what caused those the audit to occur in the first place.
These are clients that I did not work with initially. They either took their returns to a different accountant or self prepared. They made a mess. They’re coming to me to fix it. This is what I see from my experience, and I just want to share them with you.
Using Round Numbers In Your Expenses
The first mistake I often see is when self employed people use clean figures for your expenses when you’re trying to deduct them. What does that mean? That means if you are trying to deduct, let’s say your cell phone. If you write “cell phone expense, $1000”, “supplies expense, $2000”, “travel expense, $5,000”, it becomes blatantly obvious that it’s just made up. I mean, there’s a very slim probability that the numbers just happen to break out like that.
If you’re just going to consistently use clean figures like that, it’s a major risk. The tax returns that you filed, they’re just going to run it through a scanner. The IRS has algorithms that look out for that sort of thing. Clean round expenses like that will easily trigger red flags. If that’s not obvious to you, please be aware that it is true. Please don’t use round numbers in your expenses. It’s ridiculous. However, I do see that happen all the time.
Profit Equaling Out To Zero
One mistake I see self employed people make, which is quite obvious, is when they make their profit break even to exactly zero. What that means is when you have your sales, or revenue, and then you have your expenses, or deductions. When you have your sales and your deductions equal exactly out to zero, that looks fishy. Please be cautious. Perhaps that really did occur, but just know, even if that really did occur, that’s an audit risk. So just be wary of that.
Deductions Vs Sales
A common audit risk are the expense categories themselves. Some self employed people will be questioned harder than others. There are certain expense categories which should be fairly consistent relative to your revenue. Meals ,for example, are a category of expenses. If you deducted $20’000 in meals on your tax return, would that be too high? The answer depends on your revenue. If you did $50’000 in revenue and deducted $20’000 in meals, yes that’s a major red flag. This is also something that algorithms can pick up.
However, if you tell me that your sales are $800’000, deducting $20’000 in meals, now that does not sound high at all. If you tell me it’s $3Million in sales, deducting $20’000 in meals, that actually that sounds quite low. It really depends in relation to your sales.
Your Profession Matters
Another area that would get more scrutiny is mileage. When you’re filling out the business activity code on schedule C, the IRS pays attention to what field you’re in. Let’s just say you want to claim $20’000 in miles. Does that seem high? It’s hard to say. I’d need to know what field you’re in. If you’re in sales or if you’re a broker like a real estate agent, then $20’000 in miles does not seem high at all. However, if you are a bookkeeper that seems very high. It just depends on what your profession is.
Home Office Deduction Risk
An expense that is more scrutinized is the home office deduction. The amount you can claim as an office is going to be in proportion to the size of your home. If you’re going to claim something like 30% or even 40%, you’re really pushing the boundaries. If you are really using 30% of your home exclusively for business, then it makes sense to write it off. But just know, that’s going to look suspicious.
Be careful when you’re using the home office deduction. However, if you truly are using the home office as your exclusive place of business, then you are entitled to use that, so absolutely take it. I would encourage you to take it. Just be aware that using a higher percentage of your square footage for exclusive use of business does increase your audit risk.
Report All Income
In addition to these items on the schedule C, you’re also going to have your ordinary tax forms as well. Perhaps you have investment income, stock sales, or even interest income. Perhaps you have a W2 even. Know that if you receive a tax form, so did IRS. If you don’t report that, they’re going to know about it. Not reporting income will trigger a letter from the IRS quickly. If the amounts are significant it could potentially lead to an audit as well. So if you get an IRS form, please report it.