As a self-employed person—including freelancers—you likely enjoy a degree of freedom that makes your traditionally employed friends envious. Nonetheless, that freedom comes with responsibilities in the forms of tax burdens, some of which might increase the likelihood of an IRS audit relative to a conventional employee.
Because self-employed people are largely left to fend for themselves when it comes to reporting income and making deductions, the likelihood of miscalculation increases, which might raise an eyebrow or two at the IRS. Some unscrupulous filers even try to file fraudulent returns, which raises the level of scrutiny for all taxpayers.
Because of this, it’s important to follow IRS tax rules to the letter when filing as a self-employed individual. Here are seven common tax triggers found in self-employed filings that may result in an IRS audit:
1. Home Office
Many small business owners operate from their own homes to keep costs down. And while there’s nothing wrong with listing a home office deduction on your tax return, doing so can raise red flags with the IRS.
To avoid an audit, make sure only to write off the portion of your home used exclusively for work. Additionally, it’s important to avoid using home office space for other purposes, such as a second bedroom or playroom for the kids. If the space is used for anything other than work at any time, it can’t be deducted as a home office.
2. Income Discrepancy
IRS guidelines are complex, and few small business owners can afford to hire a team of accountants to help them dot the i’s and cross the t’s. Unfortunately, making even a small mistake on your tax return can leave you vulnerable to an audit.
Because the IRS receives W-2 and 1099 forms from employers and clients, they’re likely to know if you report your figures incorrectly. Be sure to check over all your 1099s to ensure they match your records, and contact your client to correct any discrepancies.
3. Undocumented Deductions
While you may be tempted to claim more deductions than are feasible to reduce your tax burden, doing so can quickly put you on the IRS’s radar. The government is on the lookout for self-employed persons who report large deductions despite earning small incomes.
To reduce your chances of being targeted, take care to report only those deductions you can back up with receipts or other relevant documentation. Some of the biggest red flags for the IRS include expensive meals, non-work-related travel, unusual entertainment and non-doctor-approved medical expenses.
4. Excessive Donations
Just as large and undocumented deductions can raise IRS eyebrows, so too can reporting excessive charitable donations. While it’s great to give money to your favorite cause, the amounts you are legally able to deduct are subject to income-based limitations that are contingent on the type of charity you’re donating to (e.g. public charity, private charity, foundation, etc.). For best results, ask your donation recipient for a written statement that includes your name and the donation amount.
5. Big Car Costs
Though it’s perfectly fine to write off mileage for these trips, self-employed persons can find themselves in trouble for reporting costs not related to the business. To protect yourself and your business, keep detailed records of vehicle usage related to your company.
Additionally, you should avoid conducting other errands or making for-pleasure stops while on your way to a business meeting. If the IRS is suspicious of the mileage amounts on your tax return, an audit may be in your future.
Another car-related discrepancy comes from not knowing what you can legally claim. Under current IRS regulations, you can either deduct business travel using the standard mileage rate or by using the actual expense method, the latter of which uses a more itemized approach. You can only pick one, however, so choose the one that you can best support with documentation (e.g. gas receipts, oil changes, etc.) so that you avoid an audit.
6. Shoddy Math
One of the biggest red flags for the IRS is an abundance of round numbers on your tax return. It’s tempting—and stupid—to round that $93 medical bill up to an even $100. This seemingly small adjustment can put you on the government’s radar. Besides, if you’re willing to round up in one area of your return, what’s to stop you from doing it in other areas?
For best results, don’t do it. Only round up cents (i.e. if you have a bill for $92.37, you should be okay putting down $93) and keep detailed receipts for all your expenses.
7. Higher Income
Earning a higher annual income is the goal of every small business owner and freelancer. Unfortunately, achieving this goal can also put you at risk of an audit. Not only does earning more make your tax return more complicated, but it also increases the amount the government can reap from an audit, making you more desirable.
While few of us would avoid earning a higher income just to reduce the odds of being audited, it is a good idea to be even more meticulous in your reporting. By staying smart and saving all your receipts, you can protect yourself and your business moving forward.
There are two big lessons to walk away with. First, if you’re unclear about the rules, go straight to the source and seek the help of an accountant or bookkeeper if necessary. Second, hold onto any and all documentation you use to support your deduction and income claims. This will help in the event of an audit.
Keeping track of your transactions can be complicated, but there are software suites that can assist you with organization and preparation. If you need more time, consider filing an extension rather than submitting incomplete or incorrect information. It’s not worth getting your paperwork in early, especially if it leaves you vulnerable to an audit or tax penalty down the line.
For a more in-depth article on filing taxes, check out our complete guide to taxes for the self-employed.