In our March 2014 newsletter, we provided a discussion entitled “What Are The Chances of Being Audited.” The article focused on the relative possibility of an audit given different levels of income. To more completely address the question of “What Are The Chances of Being Audited,” this article goes beyond income level and addresses the impact of different types of transactions and deductions on the relative chance for a tax audit.
Self Employed (Schedule C) Losses
Schedule C is the official IRS form for reporting items of income and expense as it pertains to taxpayers who are self-employed. Schedule C sources of income (“self-employment income”) are usually reported to the taxpayer filing self-employed status on Form 1099. W-2 income, on the other hand, is reported to the taxpayer on Form W-2 and not on Schedule C. Schedule C filers tend more to co-mingle business and personal expenses or to incorrectly treat personal expenses as business expenses in an attempt to hide taxable income. Tax Payer Resolution also notes that self-employed taxpayers generally fail to keep detailed, accurate, and complete accounting records that are required by law.
As explained in the Tax Payer Resolution article linked above: “The audits or examinations of self-employed taxpayers have a far greater degree of success by the IRS. The IRS’s National Research Program estimated that unreported business income by sole proprietors accounted for $68 billion (or 20 percent) of the $345 billion tax gap. The IRS estimates that as many of 70% of taxpayers who report net losses on a Schedule C have artificially inflated expenses to create losses.” Thus, taxpayers who file Schedule C tax returns reporting net losses have the attention of the Internal Revenue Service and are highly susceptible to being audited.
Home Office Deduction
The home office deduction is available to certain taxpayers who meet strict guidelines, including a business purpose for the amount claimed, as promulgated by the IRS. So strict are the guidelines that merely filing a return based in part on the home office deduction appears to be enough of a flag to increase the risk of an audit.
According to TaxBrain.com, some taxpayers have included their entire home for the deduction. However, your home office must be exclusively used for business purposes and not for other activities. The guidelines contained within IRS Publication 587 should be adhered to in order to ensure you qualify for the home office deduction.
Meals, Travel and Entertainment
In order to qualify as deductible expenditures for meals, travel, and entertainment, the expenditures must satisfy strict substantiation guidelines. The IRS recognizes that the substantiation process is a tedious process prone to “short-cutting” and therefore more susceptible to error or fraud.
IRS Publication 463 governs the deductibility of meals, travel, and entertainment. The evidentiary framework that is illustrated at Table 1-1, Table 2-1, Table 5-1, and Table 5-2 at the IRS.gov page, if complied with, will satisfy the substantiation requirements for deducting meals, travel, and entertainment. If not complied with, the deductibility of these items is at risk.
Gambling Winnings & Losses
Just when you thought that the “winner takes all” in your mega-gambling haul, you receive a wakeup call in the middle of the night from the IRS. The IRS insists on getting, and is entitled to receive, its share of your gambling winnings in the form of federal income tax. Making matters worse, you could also be in a state that taxes gambling winnings.
The following tips come from IRS Topic 419 “Gambling Income and Losses,” and are applicable to casual, not professional, gamblers.
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Gambling winnings are fully taxable and you must report them on your tax return.
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A payer is required to issue you a Form W-2G, Certain Gambling Winnings, if you receive certain gambling winnings or if you have any gambling winnings subject to federal income tax withholding.
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You must report all gambling winnings on your Form 1040 as "Other Income"
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You may deduct gambling losses only if you itemize deductions. However, the amount of losses you deduct may not be more than the amount of gambling income reported on your return.
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Claim your gambling losses on Form 1040 Schedule A as an "Other Miscellaneous Deduction" that is not subject to the 2% limit.
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It is important to keep an accurate diary or similar record of your gambling winnings and losses. To deduct your losses, you must be able to provide receipts, tickets, statements, or other records that show the amount of both your winnings and losses.
Hobby Losses
When determining a “hobby loss,” it depends on whether the activity that produces the loss is a “for-profit trade or business activity” (not a hobby) or a “not for profit non-trade or business activity” (is a hobby). If the activity is deemed to be a for-profit trade or business activity, then the loss generated by the for-profit activity is properly treated as a fully deductible loss without limitation.
However, if the loss is deemed to flow out of a true hobby activity (not for profit scenario), then the hobby loss is deductible subject to strict limitations.
Internal Revenue Code Section 183 governs the deductibility of hobby losses. Under this code section, “an activity is presumed for profit if it makes a profit in at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses).”
Furthermore, under Code Section 183, “if an activity is not for profit, losses from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts, and S corporations. It does not apply to corporations other than S corporations.”