IRS audit risks – the red flags that mean you are more likely to get a inspection

Being self-employed can be rewarding and financially beneficial, but it also increases the likelihood of an IRS audit. While overall audit rates are low, those who file a Schedule C for business income face greater scrutiny. Here are nine red flags that can trigger an IRS audit for self-employed individuals.

1. Taking excessively large deductions

• If your business deductions appear disproportionately high compared to your income, the IRS may take a closer look.
• Large losses on Schedule C are especially suspicious if they significantly reduce taxable income.
• Ensure all deductions are legitimate, supported by proper documentation, and not personal expenses disguised as business costs.
• Maintaining a separate business bank account can help justify expenses.

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2. High income levels

• Audit risk increases as income rises, particularly for those earning over $400,000.
• The IRS is under pressure to focus on wealthier individuals rather than low-income earners.
• The Inflation Reduction Act provides additional funding for IRS enforcement, meaning more audits for high earners.
• While earning more money is not a problem, be prepared for IRS scrutiny by maintaining accurate records.

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3. Writing off hobby losses

• Businesses operating at a loss for multiple years may be classified as hobbies, making losses non-deductible.
• The IRS requires businesses to show a profit in at least three of the last five years to avoid being deemed a hobby.
• Keeping detailed financial records and operating in a professional manner helps prove a legitimate business intention.

4. Claiming 100% business use of a vehicle

• The IRS rarely accepts that a vehicle is used exclusively for business purposes unless there’s another personal vehicle available.
• Heavy SUVs and trucks purchased late in the year receive extra scrutiny due to their favorable tax write-offs.
• Keep detailed mileage logs and calendar records to substantiate business usage.

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5. Trading vs. investing in securities

• Traders qualify for tax advantages such as fully deductible expenses and exemptions from self-employment tax.
• The IRS scrutinizes those claiming trader tax status to ensure they actively buy and sell securities frequently.
• Investors, who hold stocks for long-term appreciation, cannot claim the same deductions as traders.
• Trading activities must be continuous and substantial to qualify.

6. Claiming rental real estate losses

• The IRS closely examines rental losses, particularly from those who claim to be real estate professionals.
• Passive loss rules generally prevent deductions unless the taxpayer actively participates in renting the property.
• A special exception allows real estate professionals who spend more than 750 hours annually in the field to deduct losses.
• The IRS investigates taxpayers with high rental losses who also have significant income from other sources.

7. Misusing the R&D tax credit

• The research and development (R&D) tax credit is frequently abused, leading to IRS audits.
• The IRS targets businesses inflating expenses or falsely claiming routine activities as R&D.
• Qualifying research must involve experimentation, innovation, and uncertainty.
• Activities such as adapting an existing product or performing customer-funded research typically do not qualify.

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8. Operating a marijuana business

• Federal law prohibits business deductions for marijuana enterprises, even if legal in certain states.
• The IRS audits marijuana businesses that improperly deduct expenses beyond the cost of goods sold.
• Courts consistently rule in favor of the IRS in disputes over these deductions.
• Proposed federal reclassification of marijuana may change tax rules, but current laws still apply.

9. Large deductions for meals and travel

• The IRS scrutinizes significant deductions for dining and travel expenses.
• Business meals are only 50% deductible, while lavish or personal travel costs are not allowed.
• Maintaining receipts and records detailing business purposes can help substantiate claims.

Final thoughts

While self-employment offers many tax advantages, it also increases IRS scrutiny. Proper documentation, adherence to tax laws, and professional record-keeping can help minimize audit risks. If any of these red flags apply to you, consider consulting a tax professional to ensure compliance with IRS regulations.

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