Filing taxes is challenging enough, but getting audited is the stuff of nightmares. With so much on your plate already, who has time for bureaucracy?
The chances of your freelance business getting audited are low—but it is possible. According to the 2022 IRS Data Book, the number of tax audits rose in 2021, but the overall number has been steadily declining since 2012. Since the 2011 tax year, the IRS has only examined 0.55 percent of individual returns and 0.92 percent of corporate returns.
Unfortunately, as a freelancer or small business, you may be more likely to get audited this year as the IRS has hired more employees for enforcement. And the chances could increase in the future as peer-to-peer apps like Venmo and PayPal will soon be expected to issue 1099-Ks to anyone receiving more than $600 in business transactions. While the IRS has delayed the rule by a year, a bipartisan congressional analysis found the ruling is likely to target small business owners and freelancers.
5 red flags to avoid in your returns
Here are a few things to watch out for when you’re filing your freelancer taxes this year.
1. Large deductions
As a freelancer or small business owner, you can claim deductions for business expenses including travel costs, meals, subscriptions, a home office, or materials used to run your company. But if you’re claiming a lot of deductions for things that could fall into personal or family use—or reporting a large deduction despite having a relatively small income—that could set off alarm bells. It’s a good idea to keep track of all the deductions you’re claiming with receipts or other documents that prove they’re business expenses.
2. Home office deductions that don’t add up
The home office deduction is great for freelancers who work from home, but you need to be careful about how you use it. You can only claim this deduction if you use a part of your home that’s separate from personal use—working from your kitchen table won’t cut it.
So, while a spare bedroom used solely as an office space can be deducted, if you work from your couch, your living room doesn’t qualify. You’ll also need to calculate the percentage of your home office as it relates to your overall living space—you can’t claim your entire rent or mortgage.
3. A sudden change in income
For freelancers, business income isn’t always stable. Unluckily for us, a sudden flux in income, whether positive or negative, could trigger an audit. If you suddenly make more than $200,000 after making less than six figures for several years, the IRS could flag it as suspicious.
While you shouldn’t let the chance of an audit keep you from increasing your income, be sure to keep meticulous records. Consider hiring a tax professional to ensure your numbers are in order.*
4. Excessive donations
While donations to charities are tax-deductible, they are subject to income-based limitations. In addition, the total amount you can donate depends on the type of charity you’re donating to. Before donating, check what those limits are. If you’re planning to donate, ask for a receipt with your name and the donation amount.
5. Bad math
Rounding up deductions to the nearest cent might make it easier to add them up, but if there’s too much discrepancy, you could end up on the IRS’s radar. This is why it’s so crucial to triple-check your numbers and keep detailed receipts of your expenses.
What freelancers can do if they’re audited
If you’ve been selected for a freelancer tax audit, it doesn’t necessarily mean you did something wrong. The IRS uses random selection and computer screening to compare returns against similar ones and check for anomalies. If the screening detects anything unusual like a large purchase—or your return involves transactions with other taxpayers whose taxes are being examined—you may be audited. The IRS will always notify you of an audit by mail, never by phone call or email.
The IRS will always notify you of an audit by mail, never by phone call or email.
The most important thing to do if you’ve been selected for an audit is to provide all the requested documents and answer any questions. You may be asked to do an in-person interview at an IRS office or your home or business. Keep any documentation related to your taxes for three years from the date of the file—that means all your receipts, invoices, and tax files. The IRS may ask for legal papers, canceled checks, logs or diaries, medical or dental records, insurance reports, or tickets.
If you owe the IRS money, you can use a payment schedule to pay back Uncle Sam. And if you disagree with the IRS’s findings, you can file an appeal.
While no one wants the IRS to come knocking on their door, making sure you have your paperwork in order can help you settle things quickly.
*Disclaimer: This content is for general educational purposes only. We are not financial advisors, and the information here is not intended to provide specific legal or tax advice for any individual.
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Author: Moriah Costa