Tax season can feel fraught and stressful for small business owners, especially if they might run afoul of the Internal Revenue Service—a fear that many Americans share. Audits happen, but they’re fairly uncommon for most people. In 2019, the IRS audited about 1 person out of 220 taxpayers—in 2009, this ratio was more like 1 in 90.
The reduced number of audits is linked to budget and personnel constraints at the agency, not due to the tax code becoming simpler—so don’t use this data as an excuse to file your taxes haphazardly.
You can reduce your audit risk by paying close attention to your deductions and keeping detailed records. However, the best way to reduce your risk is also the most obvious: hire a tax professional.
Don’t feel like you shouldn’t take any of the below deductions if you legitimately can, though. Never pay more taxes than is legally required. There’s a small chance that the IRS might audit you even if you avoid all deductions—but with some preparation and recordkeeping, you can sail through that process as easily as possible.
1. Deductions That Trigger DIF Systems
To measure the accuracy of tax returns, the IRS uses a computer program known as the Discriminant Inventory Function (DIF) system. The system automatically compares the data you filed with information it’s received from other companies, employers, and taxpayers. If issues arise, DIF flags the questionable data for review by a human agent.
DIF scores vary depending on industries and income brackets. Your field and income will also impact the kind and amount of deductions that the DIF system considers normal.
“Different types of taxpayers and returns are subject to different DIF formulas,” tax experts Robert Finkel and Diana Española explain. “While the specifics of the program are not public, certain items appear to cause a return to be selected for examination, such as participation in a tax shelter, large charitable contributions, home office deductions, a large travel and entertainment expense, or a large automobile expense.”
Some DIF red flags are obvious incongruities, like if you and another person claim the same dependent. Other red flags are harder to generalize: for example, if your business travel deductions are 20% larger than average compared to other people in your profession. Because you can’t know for certain what will trigger DIF and what won’t, keep close attention to your business deductions throughout the year and maintain your records.
2. Unreported Income
This isn’t technically a deduction, but if you try to lessen your tax burden ahead of time by fudging your reported income, you become an easy mark for an audit. Remember, you’re not the only one sending information to the IRS—so are your clients, employers, workers, and customers. If you made money during the tax year, the IRS likely knows about it before you file anything.
3. Personal Expenses Deducted as Business Expenses
You can easily get in trouble if you mix up your personal and business expenses, especially as a sole proprietor. Keep separate accounts for your business and personal use, and always keep detailed records on anything you plan to deduct. You should be separating business from personal expenses for clearer bookkeeping anyway, not just for the IRS.
4. Large Charitable Donations
Charitable donations are encouraged by the IRS—but if your donations are very high compared to your income, the agency will get suspicious. Ensure any charity that you donate to accepts tax-deductible donations, either with 501(c)3 status or otherwise. For noncash donations over $500, you need to file Form 8283.
5. Substantial Schedule C Losses
For many small business owners and self-employed people, you will be reporting most of your income and deductions through Schedule C. If you report heavy losses on your Schedule C, your business is more likely to be scrutinized by the IRS. This is particularly true if losses on your Schedule C offset income earned by other means, like through your wages if you’re a W2 employee as well as a small business owner.
6. Meal, Hospitality, and Travel Expenses
While the IRS allows for meal deductions, you have to record the amount of the expense, the location, the attendees, and the business purpose of the meal. For travel, you must keep receipts for any expense over $75 or for lodging away from your home. Meal and travel deductions can easily trigger the DIF system if they eat up a substantial portion of your income.
7. Personal Vehicle Use
If you deduct 100% of the use of a vehicle for your business but use it as your daily driver, you risk an audit. You need to log mileage for your business vehicle as well as maintain records of the business purpose of each trip. The IRS will let you deduct a percentage of a vehicle’s cost if you keep it for business and personal use, but records are still a necessity.
8. Home Office
Like vehicles, the IRS will allow you to deduct costs related to a home office. This “office” can be any location in your home or rented property where you conduct business—but the space must be 100% dedicated to your business, even if it’s just half a dining room table. The IRS will have questions if you deduct a significant percentage of your home’s footprint, and the risk increases if this furthers a loss reported on a Schedule C.
9. Rental Property Losses
You can deduct losses related to rental property if you actively participated in renting it out or are a real estate professional, but the IRS is notorious for scrutinizing taxpayers for claiming large rental property losses. If you plan to deduct losses from a rental property and have multiple sources of income, know the IRS rules.
10. Writing Off a Hobby as a Business
The IRS allows you to make deductions for hobby-related expenses, but be wary in differentiating your hobbies from your businesses. You will become a prime target for an audit if you run a Schedule C business that could be considered a hobby at a loss for multiple years and have large sources of income unrelated to this business.