There’s one word that fills every tax-payer with dread, a harbinger of bureaucracy, the prelude to paperwork… AUDIT.
Audits can happen to anyone, but there are certain factors that make it more likely the IRS will come knocking. The bad news? Freelancers, self-employed professionals, and small businesses are 3X more likely to be audited than people working a salaried job. But being aware of some of the risk factors can give you an idea of what the IRS might be looking for and help you make sure you’re prepared.
What puts you at risk of an audit?
Being self-employed makes you eligible for a ton of sweet tax deductions, but it also means the IRS may be keeping an extra close eye on you. Audits can be the result of a random selection, or because something raised a red flag for the IRS. Here are some of the top risk factors that could trigger an audit for a self-employed professional:
1. Not reporting all your income
It may be tempting to fudge the numbers or keep some side hustle income secret, but the risks outweigh the benefits. If the tax authorities catch fraudulent activity in one of your assessments, it could lead them to investigating past years as well. If you’re earning income of (almost) any kind, you should know what you owe and pay up. This applies to tips and cash payments as well, which brings us to our next risk factor…
2. Running a cash-intensive business
If you’re running a small business or side hustle that involves a lot of cash, it may get auditors’ attention. If you own a restaurant, work in a salon, sell things at farmers’ markets, or even have a side hustle like being a dog walker, then you’re at a higher risk. The IRS knows that it’s easier to fudge the numbers and harder to keep exact financial records when you’re dealing with cash.
This means that staying on top of your financial hygiene is extra important. It’s not enough to just hold on to your receipts and financial records, you should also take notes about their purposes. These memory refreshers are important since you could be audited years later.
3. Large deductions
Remember all those fun deductions you’re eligible for when you’re self-employed? Well, they can also be a red flag for the IRS. If you’re claiming 100% of your vehicle costs, expensive weekly dinners, huge donations to charity, equipment that doesn’t make sense for your business, etc., it’s likely that alarm bells will go off. The IRS compares your claims with other people in your industry and tax bracket and will question deductions that are out of the norm.
Now, that shouldn’t scare you away from claiming everything you’re owed. Any of those things might have totally legitimate reasons, and if you can back that up then you should absolutely claim them! But just know that if a deduction looks strange, then it increases the odds that someone is going to want proof.
4. Irregular income
This is a big one for self-employed professionals. Freelancers are used to uneven income, and the cycle of feast and famine means that your tax assessment could vary wildly from year to year. A self-employed professional that goes from scraping by on their first year of freelancing to landing a massive contract in their second year could be more likely to get flagged for an audit.
Whether you’re earning a lot or not, both situations put you at risk. People who are at either end of the spectrum, high or low income, are more likely to be audited than those in the middle. It might sound counter-intuitive, but your odds of being audited increase as you earn more. In fact, self-employed professionals with gross receipts over $100,000 are 6-8X more likely to be audited.
The best offence is a good defence
You can’t necessarily stop an audit from happening to you, but you can make sure that it’s as easy and seamless as possible if it does happen. Some of these factors are unavoidable, and the risk of an audit shouldn’t scare you off from claiming deductions. When in doubt, consult with a tax professional, use common sense, act in good faith, and always have the receipts to prove it.