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How Small Business Owners Can Win The Tax Game Right Now

Joy Taylor, Tax Game

With Joy Taylor, Tax attorney and Tax Editor at Kiplinger.com

The very idea of an audit by the IRS can make strong men and women quake. As long as you don’t operate in the crooked lane, being audited is not nearly as scary as one might think, but, even so, it’s better to avoid waving any red flags

A few months ago, we spoke with Joy Taylor, tax attorney and tax editor at Kiplinger.com, about ways to avoid audits for retirees. This week she’s bringing her sage advice to address small business owners.

Quelling fears of an audit by the IRS

The likelihood of any individual getting that unwelcome notice from the IRS is .84%, that’s about one in 119 returns.

Even so, fear of an audit runs especially high with those who are self-employed. Joy explains that’s partly because small businesses are able to take many deductions that larger businesses cannot, and deductions are something that the IRS keeps its eye on. In 2015, the IRS examined between 2% and 2.5% of small business owners who attached Schedule C; that percentage is 3 times the overall rate for individuals, still not a large number, however.

Know how to play the IRS tax game.

A small business owner earning over $1 million a year has a one in ten chance of an audit. But, if you don’t make enough money or if you report large losses, your chances also increase. This gets tricky since after about three years of losses, the IRS might view your business as a hobby. The thinking here is that if you are legitimately and seriously running a business, you can deduct losses, however, your activity also must generate profit for three out of every five years to avoid sending out a giant red flag to the IRS.

Does your business sound like you’re having fun?

Joy warns that the IRS looks at Schedule Cs with large losses especially within certain areas, such as dog breeding, horse breeding, and travel writing. If it sounds like a hobby and looks like a hobby, chances are you’ll be hearing from them.

Assuming you run a legitimate business for profit, and not necessarily for fun, there are certain valid deductions you can take, with caution. If you work from home, you must use that office space exclusively as your principle place of business. Since more and more people are working from home today, the IRS has actually simplified the process so that instead of having to claim a portion of things, such as phone and electricity, a standard rate of $5 per square foot of space can be claimed, which is a maximum deduction of $1,500.

Another red flag you want to be aware of is claiming 100% of your vehicle for business, since, this is rarely the case. What you should do, however, is keep detailed mileage logs and precise calendar entries to avoid IRS scrutiny.

Joy also reminds us that in the rare circumstance that you are tagged by the IRS for an audit, it most likely will be done by mail, and, if you keep records and your nose clean, you’ll have nothing to be afraid of.

Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital.  Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions.  Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances.  The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.

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Steve Pomeranz: If you’re self-employed, it’s key to know what the IRS looks for when they scan your returns before deciding whether they should call you in for an audit.  Not knowing this, many of us live in fear of getting a notice to come into the IRS for one of those talks.  To zero in on the actual facts and maybe take away some of your concerns, I’ve asked Joy Taylor from Kiplinger to join me.  Joy worked as a tax attorney in Washington DC and has a master’s degree is tax law from New York University.  Hey, Joy, welcome to the show.

Joy Taylor: Thanks for having me, Steve.

Steve Pomeranz: Being in business for yourself can be exciting.  It can be very lucrative, but it’s also a great way to get into the sights of the Internal Revenue Service’s audit division.  In general, though, what percentage of returns are actually audited each year?

Joy Taylor: The individual audit rate, at least, last year and for the past couple of years, the individual audit rate was less than 1%.  In 2015, it was 0.84%.  That’s one in 119 returns.

Steve Pomeranz: Very unlikely that you’re going to get audited but that’s for the general population.  If you make more money, your chances go up.  If you own a small business, I suppose your chances go up as well.  Does the IRS look at small businesses in particular because small businesses are able to take so many deductions that others are not able to take?

Joy Taylor: Yes.  That’s one of the reasons the IRS looks at small businesses.  I think an interesting stat is that, as I said, the overall individual audit rate was 0.84% in 2015, but for small businesses, for sole proprietors, the IRS examined between 2% and 2.5% of those people overall who ran a business and attached Schedule C.

Steve Pomeranz: That’s three times the rate.  Yeah, it goes up about three times, right?

Joy Taylor: Yes.

Steve Pomeranz: It’s still relatively low.  At two-and-a-half returns out of every 100, small businesses are getting audited.  Still a pretty low number, yeah.

Joy Taylor: It is pretty low, however, that number can also then increase even more because of various other factors.

Steve Pomeranz: What is one of those other factors?

Joy Taylor: One of those other factors is if maybe you’re someone with a very successful small business and your small business earns over $1 million, if it’s very successful and earns over a $1 million.  Last year 10%, that’s one in 10, of tax returns filed by people reporting over $1 million were audited by the IRS.

Steve Pomeranz: Yeah, that’s quite a big difference from .84% and 2.5%.  Making over a million bucks, you have a one in 10 chance.

Joy Taylor: Right.

Steve Pomeranz: Do you also increase your chance of getting audited with a small business if you don’t make enough money?

Joy Taylor: Yes, and that is not if you necessarily buy hydrocodone with mastercard don’t make enough money, if you report large, large losses.  The IRS is looking at businesses that report large losses and, then again, your chance of an audit will increase.

Steve Pomeranz: How does that work when you’re a small business?  You’ve been in business for five years.  Maybe one year you’ve been profitable.  You’ve broken even one year.  Three years, you’ve had losses.  How does the IRS look at that within terms of deciding whether, in fact, this is a hobby or a business?

Joy Taylor: In the hobby and the business, that actually is sort of a perennial audit red flag.  The distinction is important because, for a hobby, you have to report all of your income from a hobby, but you can only take losses up to that income.  If it’s a true business, then you’re able to deduct, say, your net losses.  To be eligible to deduct the loss and to be the true business, you have to be running the activity in a business-like manner and have a reasonable expectation of making a profit. So if your activity generates profit for three out of every five years, then the law presumes that you are in a true business.  IRS looks at the Schedule Cs with large losses, and they’ll look sort of at the descriptions of the business.  For example, if your business is— a popular one is horse breeding, but horse breeding, dog breeding, coin collecting, whatever it may be, race car driving.  If it sounds like a hobby, then it’s more of a chance that the IRS might pull it.

Steve Pomeranz: The rules may be a little bit different if you’re horse breeding than if you have more of a typical business, like a printing shop, or a tailor shop, or something like that, right?

Joy Taylor: Exactly.  The IRS is not going to look at those typical businesses to see whether it’s run in a business-like manner with a reasonable expectation of making a profit.

Steve Pomeranz: I think I heard you say that if you …  Let’s say you got revenues of $100,000 in a hobby, but your expenses were $125,000.  You’d only really be able to deduct 100,000.  You can break even regards to taxes, but you couldn’t take that extra 25,000 in losses.

Joy Taylor: Right.

Steve Pomeranz: Okay, that makes a lot of sense.  What about claiming your home as a deduction?  I know that’s a big red flag.  How does that work?

Joy Taylor: Home office deductions have always been a perennial red flag, and that’s because to take advantage of the tax benefit, you have to use the space, the office, exclusively and regularly as your principal place of business.  That makes it difficult to claim, for example, a guest bedroom or something as a home office, even if you also use the space to do work.  Exclusive use means that the area has to be only used for your trade or business.  Now, a couple of years ago the IRS actually made the home office deduction a little simpler for people.  Because of that, the IRS is still looking at home office deductions, but maybe not as much as it has in the past.  As long as you still use the space exclusively and regularly as your principal place of business, there’s a simplified option for claiming the deduction.  Instead of having to go through all of the portions of the phone use for business and a portion of the electricity, et cetera, the write-off can be based on a standard rate of $5 per square foot of space used for business, which is like a maximum deduction of $1,500.

Steve Pomeranz: I got you.  If you had 200 square feet, you would fall within that $1,500, and that would be fine, but you can’t say, “I’m using it 50% for business, 50% for personal use, so, therefore, I’m only going to take 50% of that room’s use.” It has to be exclusive, all or none.

Joy Taylor: It does have to be exclusive, so exclusively used for business.
Steve Pomeranz: One other red flag that I know about is this idea of claiming 100% of your vehicle as a business deduction.  How does that work?

Joy Taylor: When you depreciate a car and take depreciation deductions, you attach a form to your return.  On that form, it includes what percentage of the car’s use was for business.  If you’re claiming 100% business use of an automobile as the individual business owner, you may very well use that car 100% for business, but agents will look.  The IRS will look at that because they know that it’s rare for someone to use a vehicle 100% of the time for business, especially in cases where the person has no other vehicle.  If it’s, for example, their sole vehicle …

Steve Pomeranz: I could just say, “I have a bicycle, and I use that for everything else, but I use my car only for business.” You’ve got to be reasonable.  You’ve got to think reasonably here.

Joy Taylor: Yeah, you do have to think reasonably.  The IRS also on vehicles in the past few years, that has become another red flag with respect to business vehicles, is the IRS is looking at heavy SUVs and large trucks that are used for business, especially those that are bought late in the year.  That’s because those vehicles are eligible for extremely favorable expensing write-offs and depreciation write-offs on your return.  In some cases, like with these very large trucks, if it’s used 100% for business, some businesses can write off the full amount of the truck.

Steve Pomeranz: Yeah, yeah, exactly.  You get a tax deduction for that, so they’re going to watch for that.  Now, unlike the home deduction where it’s exclusive use, you can allocate a proportion to the deduction for the vehicle, is that correct?

Joy Taylor:    Yes, you can.  Just make sure you keep detailed mileage logs and precise calendar entries for it.  For example, if based on your mileage log you’re using the vehicle 75% for business, then you can take either 75% of the expenses or if you decide to use IRS’s mileage allowance, the standard mileage rate.

Steve Pomeranz: Remember that getting an IRS audit is not so bad if you’re clean and you’re doing things the right way, as you should.  If you’re fudging it, then obviously you really need to worry.  You should not be afraid of an IRS audit.  Most audits really don’t ask you to even come in.  They’re done by mail, maybe by a phone interview, and so on.  My guest, Joy Taylor, from Kiplinger.com.  Thank you so much for joining us, Joy.

Joy Taylor:    Thank you, Steve.

Steve Pomeranz: To hear more about this and to join our conversation, don’t forget to go to StevePomeranz.com.  That’s P-O-M-E-R-A-N-Z.