It is now official: the IRS may initiate an audit if you have done this on your tax return

Self-employed individuals, including freelancers and independent contractors, operate differently from salaried employees. Unlike employees whose taxes are withheld by employers, self-employed taxpayers are responsible for calculating and paying their own taxes. To accurately determine taxable income, they deduct legitimate business expenses—costs that are both ordinary and necessary for their trade or profession. That last bit is key - they have to be ordinary and necessary for carrying out their business.

For instance, expenses such as office supplies, business-related travel, and rent for a dedicated workspace can be deducted. However, personal expenses, even if incurred during business activities, are not deductible. Examples include personal clothing (unless it’s a required uniform), meals, and entertainment. Misclassifying personal expenses as business deductions can raise red flags with the IRS.

Requirement to keep accurate and detailed financial records to avoid problems with the IRS

Maintaining accurate and detailed financial records is crucial. Self-employed individuals should keep comprehensive accounts that serve as the foundation for their tax returns. This includes invoices, receipts, and logs that substantiate income and expenses. Proper documentation not only ensures compliance but also provides evidence in case of an audit.

The IRS has identified certain audit triggers, particularly concerning self-employed taxpayers. Claiming excessive or questionable deductions, especially those that don’t align with reported income or industry norms, can prompt scrutiny. For example, disproportionately large home office deductions or consistent business losses may lead the IRS to question the legitimacy of the deductions being taken.

Remember, the IRS has databases that show what income and expenses generally are across every type of business. Where a taxpayer’s numbers are out of the ordinary for their line of business that can trigger red flags.

IRS audits triggered

If the IRS detects inconsistencies, it may initiate an audit, which can be conducted either in person or remotely. Taxpayers will receive an official notice detailing the scope of the audit and the documentation required. It’s imperative to respond promptly and provide all requested information. Failure to do so can result in adjustments to the tax return, penalties, or more severe consequences.

Penalties for inaccuracies on tax returns can be substantial. The IRS imposes an accuracy-related penalty of 20% on the portion of underpaid tax resulting from negligence or disregard of rules. This includes substantial understatements of income tax, defined as understating tax liability by more than 10% or $5,000, whichever is greater. Additionally, erroneous claims for refunds or credits can incur a 20% penalty on the excessive amount claimed.

It’s important to note that penalties can apply regardless of intent. Even unintentional errors, if deemed negligent, may lead to penalties. However, the IRS may provide relief if the taxpayer can demonstrate reasonable cause and acted in good faith.

Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Tax laws are complex and subject to change. If you have questions or concerns about your specific tax situation, it’s advisable to consult a qualified tax professional.

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