Everyone wants to avoid a tax return audit, especially those who earn self-employment income. The challenges inherent in keeping organized records and properly using deductions can increase the risk of an IRS audit flag. To protect yourself and your business, consider the answers to these common tax return audit questions asked by people who are self-employed.
How Many Years Can I Report a Loss Before Getting Flagged for an Audit?
There's an IRS rule called the Hobby Loss rule: If a business reports a net profit in at least three out of the five years, it is assumed to be a for-profit business. However, if the business reports a net loss in more than two out of five years in operation, it's assumed to be a nonprofit hobby business.
If you are legitimately trying to make a profit but have run into tough times, and you're audited, you'll need to answer the following questions to prove it to the IRS:
- Is your intention to make a profit?
- Do you depend on that income?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you done anything different to increase profits?
- Do you have expertise in this field?
- Have you made a profit in similar activities in the past?
- Is the business profitable sometimes?
- Is it reasonable to expect a profit in the future?
How Much Income Can I Receive Without Having to Report It?
None. The IRS requires you to report all of your income, even if it is a payment as little as $20.
The IRS indicates it is a common misconception that if a taxpayer does not receive a Form 1099-MISC or if the income is under $600 per payer, the income is not taxable. There is no minimum amount that a taxpayer may exclude from gross income.
What Are Audit Red Flags for a Self-Employed Business?
- Home office space deductions
- Meals, travel and entertainment
- Writing off a vehicle
- Consecutive years of income loss (hobby business)
- Hiring family
- Disproportionate income to lifestyle
What Is the Chance That I Will Get Audited?
Based on figures from 2011, figures show that for those making less than $200,000, only 1% can expect an audit. Obviously, your chances to be that 1% are much greater if your return raises an audit red flag.
For those earning more than $1 million annually, your chances of being audited have quickly risen to 12%.
Anyone earning more than $200,000 but less than a million can expect to be audited at around 4%.
What Can I Expect if I Get Audited?
The majority of all audit notices come in the mail. Only some IRS audits actually involve a face-to-face meeting between the taxpayer and an IRS agent—most are carried out entirely through the mail.
The IRS will request more information about income, expenses, itemized deductions, and other items on your tax returns from as far as three years back. You can request a face-to-face audit if what you have to show is too difficult to mail. The length of audits vary depending on their complexity and a variety of other factors.
After the IRS completes the audit, you'll be notified of the findings—which could mean that you owe additional money. If needed, you can arrange a payment plan. If you disagree with the findings, you can request mediation or file an appeal.
Your best protection to survive an IRS audit? Have detailed documentation to back-up all deductions. Keep each year’s tax information, including receipts, in an organized fashion somewhere safe. The last thing you need is your tax documents destroyed due to a natural or man-made disaster.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.