The Internal Revenue Service is as close to a modern ogre myth as there is. Often described in terms similar to an evil creature like a troll, who waits for us to cross the bridge and then demands payment, the agency is actually just a cold bureaucracy, inefficient on good days, but still determined to squeeze you for every tax dollar it thinks you owe. Or that you can’t prove you don’t owe.
Fortunately, there is good research on which taxpayers and activities are most likely to catch the attention of the IRS’s computers, leading to a red flag that gets the special touch of a human IRS agent. Here are the things that are most likely to get a freelancer or self-employed business owner audited, along with ways to prepare if that happens.
Not reporting all income.
When you provide services to a business, they will report that as an expense to the IRS, which means they will issue you a Form 1099 (if you earned more than $600). Take Uber, for example. If you drive a few fares around, the Uber system tracks your income and the company reports that to the feds. So the IRS already knows you earned the money, and not reporting it is an easy catch for IRS computers.
Not filing taxes at all.
When businesses (your employer or freelance clients) file their tax returns, they include information on who and how much they paid for their business expenses. If you don’t report receiving that income, the IRS will notice and start an investigation to see where that money went. When they notice you haven’t filed a return, you could be looking at a lengthy review that goes back several years, and that could result in hefty fines, back taxes and even jail.
Claiming losses for a hobby business.
If you have had a small businesses for a few years, filing it on a Schedule C on your 1040 income tax return, and your expenses always add up to more than your income, that means you aren’t making money. This can be a red flag for the IRS, since they consider an activity that consistently loses money to be a hobby, not a business.
The home office deduction.
To claim a home office deduction, the area you claim must be used exclusively for purposes related to that business. It can’t be your guest bedroom or a “man cave” that is used for entertaining friends. The IRS looks closely at this deduction because it also allows the taxpayer to write off utilities and other expenses related to that portion of their home.
Claiming 100% business use of your car or truck.
It can be tempting for many self-employed taxpayers to claim their vehicle is always being used for business purposes. But just putting a sign on your car doors or windows doesn’t make it so. Freelancers and Schedule C business owners rarely own a separate vehicle for their business activities and one for personal use, so claiming such is a red flag. It is better to keep logs of your mileage for business use, with details about the travel purpose, and claim the mileage rate.
Going to town on business meals, travel and entertainment. Excessive deductions for business expenses related to travel and entertainment are likely to get the attention of an auditor. If the business is low on revenue and high on expenses, the agent will be critical of meals that are likely personal and can’t be documented. Keep records of not only where you spent the money and how much, but also which client it involved, who else was there, and the business discussion or purpose.
Running a cash-only business.
Just like tipped employees, the IRS assumes that freelancers and self-employed individuals make a certain amount, and expect documentation when the taxpayer claims otherwise. A cash-only business will certainly gain the attention of the IRS.
Shady tax preparer = shady deductions.
While most tax preparers are honest, there are some out there who make promises of guaranteed big refunds that seem “too good to be true.” They are. No tax preparer can guarantee you a refund of any size before they’ve actually looked at your information, and a person that does is likely going to falsify inappropriate deductions and credits. This will get you into big trouble with the IRS (fines and back taxes, at least). Avoid tax preparers who only open an office for a couple of months a year. The safest bet is to go to a CPA who has the experience and ethics to prepare your taxes legally, while also looking out for the most beneficial tax breaks that you actually qualify for.
Preparing your tax return by hand. The IRS prefers electronically prepared and filed returns because they can be instantly fed through the agency’s computers. This speeds the processing of the millions of returns they handle each year. A return that has been prepared by hand requires a data entry person at the agency to enter the information manually, which means not only added attention from the very beginning, but also additional chances of errors being made.
Higher income = higher audit risk. It may be the price of success, but the IRS is much more likely to audit individuals with higher income. So, good luck on your freelancing or small business, but be prepared by following the other advice in this article.
Now that it's tax season, take these "pet peeves" of the IRS to heart and make the acquaintance of a reputable CPA familiar with issues related to self-employment and freelance businesses to prepare your taxes. The CPA for Freelancers team is also available for tax preparation, so learn more about hiring us!
Jonathan Medows is a certified public accountant licensed in New York, New Jersey, Maryland, and Pennsylvania. He is also a recognized expert in taxation for freelancers and the self-employed—often tapped for his expert knowledge and perspective on self-employment taxation by national and regional publications such as The New York Post, BusinessWeek, Forbes taxation blog, WebCPA, CPA Practice Advisor, and others. You can read some of Jonathan’s press coverage here.
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