First, here’s the bad news:
If you work at home, you’re far more likely to be audited by the IRS than an employee.
In fact, according to the National Association for the Self-Employed, taxpayers who file a Schedule C (i.e., Form 1040 Profit or Loss From Business) have triple the chance of being audited. Why are small business owners and those who work at home targeted more heavily by the IRS?
It’s complicated: Big corporations typically employ people full-time; many corporations even require that their employees perform no paid work outside the company. Thus, the W-2 form that is sent to an employee’s home is fairly simple and often reports his entire earnings for the year. The employee then inputs his W-2 numbers and his taxes are filed. Easy.
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Compare this with a freelancer or someone who runs a small business. There are often multiple W-9 and 1099 forms as well as the Schedule C to contend with; such forms require dealing with business profits and losses as well as self-employment tax.
Business deductions and depreciations become tricky when you are accounting for the partial business use of your home. Likewise, if you sell any retail goods, you must report and send quarterly sales taxes. Finally, if you are experiencing several years of net business losses, you might not even have a business on your hands but a hobby, at least according to the IRS.
A greater likelihood of omissions and errors: Employees might have only one source of reported income; however, for those who work at home, this scenario is highly unlikely. Freelancers may deal with 50 or more clients over the course of a year, with each client then sending her own 1099 form come tax time. The chance of having a document get lost in the mail or go unreported is high. Because the IRS performs regular document matching on tax filers, freelancers are just more prone to being audited.
Likewise, there is a higher risk of a freelancer making a math error or just plain forgetting to include the work he completed, especially if it occurred at the start of the last year. A client could also be at fault if, for example, she miscalculated how much was paid out to the freelancer.
What can you do to avoid a tax audit?
1. Be careful with those business deductions.
Business deductions for a home office, for example, only count if you’re not also using that office as a bedroom or playroom for your children. This is why it’s highly recommended that, when you’re starting out in your work at home business, you designate specific work areas and even take photos of them for verification purposes.
Other business deductions get a bit dicier- you might use your vehicle for both business and personal purposes, for example. That’s fine, but if you’re going to deduct the use of your car on your tax return, then make sure you’ve recorded the details of each of your business trips, including mileage, destination and purpose.
A high ratio of business deductions to earnings can also set off a red flag; if you’ve claimed $30,000 in deductions to $50,000 of earnings, you can almost bet that the IRS will be taking a closer look at your Schedule C.
2. Is your “business” profitable?
It’s understandable that, in the first few years of your work at home venture, you may not make a net profit. However, if you notice that, year after year, your business activities result in an overall loss, then you may actually have what the IRS calls a hobby.
According to the IRS, a business should make a profit in at least three of the last five years. If it doesn’t, then you may need to file your not-for-profit losses using a Schedule A instead. Because there are different reporting requirements for a business versus a hobby, you could become an ideal candidate for a tax audit if you ignore these regulations.
3. Do the numbers really add up?
If you work at home, you may have had to purchase business equipment including a computer, printer, etc. All these business expenses are subject to yearly depreciation, which is fine if you keep track of the actual depreciation amount year-over-year. However, if you forget how much money you actually deducted and over-deduct, the IRS may be sending you an audit notice.
When you calculate how much you spent on new phones, cameras, etc. and start rounding up your numbers to, say $600 for recording equipment or $900 for hard drives, that also sets off a red flag. In essence, rounding your numbers tells the IRS that you’re not keeping exact records of your business-related purchases (and are possibly inflating your figures).
How to reduce your chances of a tax audit
If at all possible, have your taxes input into some kind of software program like TurboTax or TaxACT. If you want to file your taxes for free, the IRS offers its own Free File software program. Avoid simply calculating your taxes on a paper form, which is highly likely to lead to a math or other error.
Hire a tax professional.
You know those business expenses and deductions mentioned earlier? It may be time to deduct another business expense- that of hiring an accountant or tax professional. You might even receive a bigger tax return thanks to the professional finding additional business deductions or credits for you.
File as late as possible.
There is some debate about whether filing your taxes as close as possible to April 15th really lowers your chances of being audited, but some businesses and tax professionals swear that it does. Some professionals even advise filing an extension on your taxes, allowing you to file as late as October 15th.
If you are a meticulous and organized individual who keeps all your tax files, business receipts and forms, in one place and maybe even goes over your taxes every quarter, then you’re already one step ahead of the tax auditor. However, most of us (myself included) could probably use some “encouragement” in keeping better records and going over our expenditures more regularly. Don’t let that encouragement come in the form of a tax audit.
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Set up a system now that involves going over your earnings and losses every month/quarter, or hiring an accountant, or at least setting aside a designated area of your home for all your tax forms and receipts. Then, stick to that system throughout the year. Consider it one of the tasks of running your business. I guarantee that you’ll breathe much easier come next April 15th.