Making Life Less Taxing: Home-Based Businesses and Audit Risk

For my first few posts, I have decided to address questions that frequently come up during my initial consultations with new clients. Here is one about the audit risk aspects of operating a home-based business:

Q: I operate a small business out of my house. The thought of a potential IRS audit makes me lose sleep at night. Is there anything I can do to eliminate or reduce my chances of being audited?

A: There are many ways to minimize your chances of being audited. First and foremost is to ensure that you avoid some of the more highly audited forms.

As a Sole Proprietor (sometimes referred to as a DBA), you are required to report your business income and expenses on Schedule C. Filing this schedule means that you fall into the highest audit risk category and find yourself with an audit risk of approximately 2.7%. A simple remedy to this problem is to incorporate. By incorporating you reduce your risk of an audit to approximately .3%, making you about nine times less likely to be audited in a given year.

Another form that shifts your tax return into the audit field at an alarming rate is Form 8829 (Expenses for Business Use of Your Home) which is used to claim the home office deduction. This form tends to catch the eye of the IRS due to the fact that many people have abused this deduction in the past by claiming a larger home office than they actually had or by deducting expenses on an office that is not completely dedicated to business use. In addition to the huge audit risk that this form creates, the home office deduction typically costs you more taxes in the long run due to the reduction of your capital gain exclusion in the year you sell your house. So, why draw unwanted attention to your tax return if you are not even receiving a financial benefit?

Other simple tips to protect yourself from an IRS audit include not having your tax return prepared by hand, making sure your reported income supports your living expenses and other deductions, not rounding off deductions (round numbers make it appear that you are guesstimating while exact figures appear to be taken from actual records) and hiring a reputable tax preparer to prepare your return. Tax preparers whose tax returns are audited frequently will be flagged as disreputable tax preparers opening up their entire client base to IRS audits. If your tax preparer is "creating" deductions for you or generating large refunds that you know you are not entitled to, it is only a matter of time before his scam comes crashing down.

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