Top 7 Schedule C Audit Red Flags
Did you know every year the IRS selects 0.05% of tax returns for audit? Schedule C filers are more likely to get picked since it offers incentives that self-employed people can exploit to reduce their tax bills. There are red flags you should be aware of to prevent this. Here are the top 7 Schedule C audit triggers that will lower your chances of being audited.
1. Income Threshold
Statistics say that if you earn more your odds of being audited increase exponentially.
If you report your income between $20000 and $1 million on Schedule C your chances of being audited is 1.4%. And for those who earn more than that their chances are increased to 3.23%.
2. Cash Intensive
Gig workers, restaurants, and convenience stores are often cash-intensive businesses and IRS keep a close eye on them since there are chances that business might have under-reported their income. This is what triggers an IRS business audit.
If the IRS found that you hid your income you will be forced to pay back taxes along with heavy penalties and interest.
You are required to report cash payments over $10,000 on Form 8300. Keep proper records of receipts so you can present them as evidence when auditors arrive.
3. Mathematical Errors
When you file a schedule and made small errors in calculating your income taxes it can set IRS alarm bells ringing. This may sound weird but this is one of the IRS audit triggers for Schedule C. And they have a good reason for it.
If you are not being careful while calculating taxes which are important then chances are you might not be vigilant in recording your financial transactions and reporting profit or loss.
4. Dramatic Changes In Income Or Expenses
Some small businesses have peak seasons which means there are months in a year they do well. The sale will fluctuate. Similarly, there are bad years for business due to unforeseen situations for e.g the recent pandemic.
If income declines due to this then it is understandable. But let’s say you have shown a profit of $300,000 in the previous year and this year it is $50,000. And there appears to be no reason for this drastic change. This unusual decrease will raise a red flag and will likely be one of the IRS business audit triggers.
5. Excessive Tax Deductions
One of the Schedule C audit triggers is excessive tax deductions. Self-employed people are allowed to reduce their taxable income using these deductions. While you can claim business expenses that are justified, there are instances where excessive claims have been made. The IRS knows this and keeps a close eye on them.
As long as you claim expenses that are ordinary and necessary in your business you have nothing to worry about.
To discourage businesses from claiming disproportionate deductions IRS checks following deductions with more vigilance.
Meal and Travels
Home Office Deductions
The ways of the world have dramatically altered during the pandemic when “work from home” became the new normal. So it is justifiable to claim a home office deduction. But since the rise has been drastic therefore it has been scrutinized more often.
Small business owners may use their personal car for business purposes or have a car that they exclusively use for business. They can either use the actual expense method or standard mileage rate to compute the business car expenses. IRS keeps a close eye when you claim this because of the complexity involved.
6. A large Number Of Independent Contractors Vs Employees
To avoid federal and state taxes the businessman prefers hiring independent contractors. Unlike W-2 employees, independent contractors are liable to pay their own Social and Medicare taxes.
This is used as a tax-saving strategy and it is legitimate unless the independent contractors are in reality turned out to be the employee. The IRS determines whether a person is an independent contractor or employee based on the degree of control and independence. So make sure you don't misclassify your workers.
7. Claiming Continuous Business Losses On Schedule C
You start a business with the intention to make a profit and it is normal in the early years to generate a loss. But if you report losses year after year then it may make your activity suspicious and the taxman is going to come after you.
They want to know whether you are genuinely pursuing a hobby or business because IRS allows you to deduct business expenses, not hobby expenses.
If you are vigilant about these Schedule C audit triggers you will decrease the probability of getting an audit. However, even if you keep everything right there is a slim chance that you might get picked up for a tax audit. Keep your records in order and don’t panic when you receive an email from the IRS. Consult a professional and get back to them in a timely manner.