Schedule C Audit Traps, Help for Small Businesses

Businesses, especially freelancers, independent contractors, and small business owners, will use Schedule C of Form 1040 to report business income and expenses. A series of losses or heavy deductions may cause questions to be raised as to whether an activity is conducted for profit rather than as a hobby.

By knowing the rules of the IRS, Schedule C filers can be prepared to prevent problems with the IRS. Learn about sales tax audit procedures that can help you resolve your issues with ease.

The issue of profit motive: Business versus Hobby

For most intents and purposes, the IRS considers whether you run an activity with the primary purpose of making money. Being a hobby is not a matter of making a loss on an activity. Similarly, just making occasional profits isn’t enough to prove it is a business.

The 3/5 year rule is one rule that is often heard. In general, if an activity has made a profit over the last three years, the IRS considers it to be a business activity. Certain horse-related activities have a two-out-of-seven-year test.

Just because the IRS says it is a hobby doesn’t necessarily mean you failed the three-out-of-five-year test, however. The overall facts and circumstances can be taken into consideration by the IRS.

What is the IRS looking for?

Examiners are able to observe the level of commitment and consistency of your activity. Factors may include:

• The need for a complete and accurate set of books and records on the books and records policy.
• If you know a little about business, or you want to consult a professional,
• The amount of time and effort you will put into the activity
• If you’ve altered your approach in order to make your business more profitable,
• Has the activity increased or decreased in value?
• Whether you depend on the activity for income
• Your profits and losses track record

A business, whether it’s a successful business, can have startup costs, bad years, or experiences where there is a temporary loss. The vital point is to show that you are really making money.

Home Office Deductions

When the claimed space is too large or is not IRS-compliant, the home office deduction can draw the IRS’s eye.

In general, the area must be used regularly and exclusively for business and comply with the following requirements: a principal place of business or other qualifying use.

Keep documentation showing:

• The dimensions of your space and home.
• The way the business area is utilized
• Mortgage interest, rent, utilities, insurance, and other related expenses
• The amount of the deduction supported by the calculation.

Even if you often work at the kitchen table, don’t use it as your office. You must talk to professionals (like a federal tax attorney) who can help you during difficult times.

Vehicle Expenses

Another common issue that Schedule C taxpayers face is vehicle deductions. There should be a distinction between personal and business driving. Personal and business driving should be differentiated.

Keep a current mileage record to document:

• Date and destination
• Business purpose
• Business miles
• Total miles (if applicable for the method you selected)

Without supporting documentation, it can be challenging to substantiate the number of business miles for thousands of business trips at the end of the year.

The Following Tips Will Help You Minimize Audit Risk:

1. Differentiate between business and personal finances. Opening a business bank account simplifies record-keeping of business transactions.
2. Maintain receipts and records. When there is more documentation available than credit-card statements, do not assume that the credit-card statement is enough.
3. Report all income. While you may get Forms 1099-NEC, 1099-K or other forms reporting income, you are not just obligated to report what you see on these information
4. Be reasonable. When large deductions are made that are not well-documented, you may find yourself facing questions.

There is no automatic presumption that a business is a hobby if it has Schedule C losses. Taxpayers need to be able to prove a business purpose and substantiate all deductions, though. If your return is audited by the IRS, good records, realistic expenses, and business practices can make a big difference.