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.
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.
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.
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.
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.
Read now: IRS employees who accepted severance pay were told to remain in their positions until May 15.
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.
