When Congress passed the Inflation Reduction Act, it secured funding for a myriad of projects, from green energy to potential reduction in prescription prices and increased tax rates on certain corporations. It also allotted an additional $80 billion to the Internal Revenue Service (IRS) over the next 10 years, including $45.6 billion for enforcement of the tax code.
What will the IRS likely do with a significant chunk of the money? More audits. By June, 21 million returns had yet to be processed. The funds from the Inflation Reduction Act will seek to speed up that issue but will also provide the IRS with more resources to conduct audits. And one group of taxpayers that must protect against such audits are those working as self-employed or solopreneur, whether as sole proprietors, limited liability corps. (LLC) or S-corps.
It’s certainly not a shift that should scare people from self-employment. While the $45.6 billion can be used to fill IRS agent roles, the agency will also likely use money to fund technology upgrades and more administrative positions. It remains unclear how much the audit activity will increase. As of now, less than 1% of taxpayers experience an audit in a tax year, so the odds remain heavily in your favor.
But working on your own can lead to the potential for increased scrutiny by the IRS. It’s a group of filers that the IRS finds errors, making an audit profitable.
By watching for these red flags, though, you can better ensure your taxes remain on the up-and-up, preventing a closer look by Uncle Sam.
Red Flag #1: Make More Money
Believe it or not, the highest percentage of those that receive audits make less than $25,000 per year. Those making under that mark were audited at a five times higher rate than anyone else. But the group that may receive the most attention due to the new act are those making far more.
After President Joseph Biden signed the Inflation Reduction Act, Treasury Secretary Janet Yellen sent a letter to the head of the IRS, Charles Rettig, directing that the funds not be used to increase audits on those households or small businesses making less than $400,000 per year.
Whether that holds true, time will tell. But, in general, those making more in self-employment should do more to protect from audits. It’s simple profit-loss dynamics at play. It costs the IRS money to run an audit. Therefore, they will want to audit those returns that have the highest chance of netting additional revenue. When looking at a self-employment return, particularly among those that make more money, the ability to question certain deductions and income make it more likely that the IRS finds mistakes.
Working with a qualified certified public accountant (CPA) that specializes in self-employment income will help avoid this potential, while recognizing where you can deduct.
Red Flag #2: High Amount of Deductions
One of the benefits of self-employment, whether you’re running a business, operating as a contractor or working as a freelancer, is the ability to deduct business expenses. This ability can greatly reduce your net income and lower your tax liability. But the IRS also takes a close look at these deductions. The more you deduct, the likelier they will argue a discrepancy.
There are certain deductions to be more careful of than others. For instance, if you work from home, you can deduct a portion of your office that you use primarily for business. But if you stretch the square footage significantly or try to write off your entire mortgage, then that will raise suspicion. You can only write off the percent of the home you use primarily for your business.
Another area that businesses try to bleed savings is in a company car. While there are certain industries where having a specified company car is required, many self-employment roles don’t. If you’re writing off a company car, while also reporting as married, filing jointly, with multiple children, then the IRS could very well surmise that the company car isn’t only used for business. If you can prove it is, then deduct the whole thing. If you can’t, then be careful on how much of the car you deduct. It’s like the home office – only deduct the percent of the car used for your work.
Finally, while not a deduction, businesses that often deal with cash often underreport a significant amount of income to the IRS. If your business gathers a lot of unreported cash, then there’s a greater chance you could see an audit notice. Keep good records of what you bring in if you’re reporting all your income, even if it’s in cash. And if you’re trying to avoid the IRS, watch out for how much you deposit into a bank. Financial institutions will often report suspicious activity if they notice multiple deposits across a few days that are just under the $10,000 limit that requires them to flag to the IRS.
Red Flag #3: You have certain business designs
One of the most common business set-ups to receive extra notice from the IRS are those that operate as a sole proprietor. If you report more than $100,000 in such a design, then you must be more careful – especially if you operate in a cash-heavy business. Also, if you report a loss while operating as a sole proprietorship, then expect significant scrutiny. Individuals sometimes try to cut taxes by using a loss on the sole proprietorship to discount gains elsewhere. But the loss has to be legitimate. And you must have the ability to use the loss to cut wage gains.
Another setup to keep a close watch on is when you’re a partner in a partnership or LLC. When operating a professional service, like accounting or law, you may collect a regular salary from the organization then also collect distributions from the profits of the firm. A 2017 court ruling said that the profits distributed must be filed as self-employment income and you must pay self-employment taxes – like Social Security and Medicare – on the income.
The IRS has taken a particular interest in this design, ensuring that its reported correctly. And with more agents at their disposal, then they will have an increased ability to focus a stronger eye on this concern.