There are lots of IRS audit myths floating around, and small business owners ask lots of questions. For example:
- Do I have to report all my 1099 income?
- Will I get audited if my business doesn't make a profit?
- What business tax deductions will trigger an audit?
This article reflects changes in business tax deductions in the 2017 Tax Cuts and Jobs Act. Most of these changes are effective with the 2018 tax year.
And more. Here are some commonly asked questions about IRS audits, and situations in which the IRS might audit a business:
1. Should I take the home business space deduction? I've heard the IRS looks closely at this deduction.
The home office space tax deduction has become easier to get, with a new simplified deduction calculation from the IRS. The higher the amount of the deduction, the more closely the IRS looks at the tax return. What they are looking at is whether you are claiming this deduction legitimately, for a space used "regularly and exclusively" for business purposes.
The IRS can - and sometimes does - visit your home to make sure you are using your business office space according to IRS regulations. That means NEVER using the space for anything but business. Deductions have been denied for even a once-a-year personal use. Look at your space as the IRS might look at it, to see if you would pass the test.
Read more about what the IRS says about Home Office Deductions.
2. Can I claim business use of a car?
Yes, but the trick here - as with all business tax deductions - is to be able to prove that business use. You must use the car at least 50 percent of the time for business purposes. You must have complete, accurate, and at-the-time records for all business driving, not records put together in January for the past year. And don't try to claim that you used the car 100% for business use.
Read more about what the IRS says about business use of your car.
3. How much of meals and entertainment expenses can I deduct? What's "excessive"?
The new tax law has eliminated deductions for all entertainment expenses. None, zero. But most meal expenses continue to be deductible using the 50-percent rule. But even so, don't overuse these expenses, trying to hide personal expenses or to disguise entertainment expenses. As with other items in this list, the higher the amount, the greater the risk that the IRS will call a "red flag" on you.
Read more about business entertainment expenses in IRS Publication 463.
4. I have several years of losses for my business. Is this going to be a problem?
This is a tough one to answer, because each case is unique. The IRS has some guidelines for what are called "hobby losses" - trying to claim business expense deductions for an activity that's really a hobby. The IRS says,
You can generally deduct hobby expenses, but only up to the amount of hobby income. A hobby is not a business because it is not carried on to make a profit.
The IRS reviews several factors in determining whether your activity is a business or a hobby. It looks at whether you have made a profit in some years. The IRS says, "An activity is presumed carried on for profit if it produced a profit in at least 3 of the last 5 tax years, including the current year." But note that several other factors come into the determination, including:
- Whether you conduct this activity in a business-like manner
- the time and effort you put into it
- whether you depend on this income
- whether the losses are beyond your control, as in the startup phase
- you can show your intent to make a profit.
Attempting to deduct losses from a hobby activity on Schedule C can cause the IRS to look more closely at your return. Artists (painters and writers, for example) often don't make a profit early on, so they must work harder to show business intent.
5. My 1099 income doesn't match my tax return income? What do I do?
You must report ALL business income, even if you don't receive a 1099-misc form. Your 1099 income is income you receive by working for someone else during the year. Your 1099 income might not include all of your business income, and you may not have 1099 income if you were paid less than $600 by one person.
One of the biggest audit triggers is mis-matched income. If you receive a document showing income, including an IRS Form 1099-MISC for independent contractor income, you must include that income in your tax return. Not reporting income is one of the best ways to get audited, and penalized. Turn your 1099-MISC form over to your tax preparer so it gets recorded along with any other business income. If recorded properly, the 1099 income should not be double-counting your business income.
6. If I file an extension, will it trigger an audit?
The IRS makes it easy to file an extension application, and it doesn't make sense that something this easy should be an audit trigger. Kelly Phillips Erb (TaxGirl), writing for Daily Finance in 2009, says "filing an extension might even reduce your chances of audit, because it gives you more time to gather last year's business information to find more deductions and make better decisions." Just be sure to pay the tax due by the tax due date, to avoid increased IRS scrutiny of your return. Failure to pay taxes by the due date can result in fines and penalties.
Disclaimer: The information in this article and on this site is not intended to be tax or legal advice. The author is not a CPA or attorney, and is providing general information only. Laws and regulations change, and every business situation is unique. Discuss any actions or decisions that can have tax or legal implications with your attorney and a tax professional.