There are some common myths circulating about tax audits that can cause taxpayers to fear making mistakes on their tax returns. The reality is that mistakes happen. Be honest when filing your taxes and report your data as accurately as possible. If you’re honest on your tax return, you’re unlikely to make significant mistakes, and in most cases, significant mistakes only result in further taxes or penalties.
Let’s review and dispel some common tax audit myths.
Myth 1: Filing an extension means you will get audited
Filing an extension doesn’t make a difference at all. Back in the days when the IRS was running a massive statistical sampling audit program, it selected random taxpayers from the entire pool of tax returns and extensions. Those tax returns were audited line-by-line and were a nightmare. After many complaints from taxpayers and Congressfolk (who were also targeted), the IRS found a better way to select tax returns for audit.
These days, the IRS looks for certain inconsistencies or ratios that stand out from the norm. The IRS doesn’t want to waste its limited resources by auditing tax returns that won’t generate any additional revenue.
Tip: Don’t worry about filing an extension. In fact, most businesses should file an extension to give themselves time to finish up accounting, and to evaluate business profits and deductions.
Myth 2: Claiming an in-home office deduction means you will get audited
When only a small percentage of the population had an in-home office, this might have been true. Today, multitudes of small businesses are started and run in the home. And many stay there for the financial benefit of not paying rent. So, using Form 8829 is no longer an audit trigger.
However, certain things will attract the IRS’s attention when you have a home office deduction. What should you avoid?
- Having a regular business address and claiming a home office deduction
If you already have a business location, you should be using that for all your business transactions. There are certain instances where you can get away with having a business address and a home office. But you must be prepared to provide documentation about how and why both locations are legitimately used for business. To avoid an audit, include a detailed statement with your tax return with your explanation and documentation about the legitimacy of both locations.
- Reporting rent expenses on Schedule C, line 20b
To the IRS computer, this looks like you have an office elsewhere and an office in-home. If you have legitimate rental expenses, like storage, consider reporting those costs on Part V of the Schedule C, as Other expenses.
- Reporting utility deductions on Schedule C, line 25
All home office utility expenses should be reported on the Form 8829. If you are showing utilities for the other business location, see #1.
Myth: Deducting meals, entertainment and travel expenses means you’ll get audited
Those who deduct legitimate business expenses rarely have a problem. But don’t get greedy. Don’t write off every meal because you used the word “business” while you were out with your friends. That doesn’t make it a business deduction.
Tip: Look over your business’s net profit (or loss). Are your meals, entertainment and travel expenses a large percentage of your sales? Say, over 10 percent? If you still show a profit, you’re probably fine. But if those expenses are over 25 percent of your gross income, make sure they are completely legitimate, and backed up by receipts and appointment data.
Myth: Showing losses year after year will result in an audit
Well, this is only partially a myth. If you’re truly running a business, you should show a profit at some point. If you’re not showing a profit, why are you investing your time and money in this activity? The IRS frowns on people who deduct their hobby expenses to offset their wages and other income, simply to reduce their taxes.
In general, whenever you have legitimate expenses and receipts to back them up, claim them. Don’t let fear of an audit prevent you from deducting expenses you’re entitled to use. Being as honest and accurate as possible means you’re unlikely to make significant mistakes, and thus less likely to be audited.