Continued from IRS Audit Red Flags – Part Seven – Schedule C Expenses
Small business losses/Schedule C losses (especially over multiple consecutive years and low income/high deduction types of businesses)
Many of my frustrated, wage earning, tax preparation clients ask me all the time if they can lower their tax liability by starting a “business” and deducting their expenses. I caution against this idea for several reasons. For starters, most taxpayers fail to consider the material participation requirement when launching their new business. As such, they deduct income that should be characterized as a passive loss against active income and get nailed by the IRS in an audit. Think about it: How many people do you know with full time jobs that spend 750 hours or more in another business? Probably not too many.
In addition, side businesses that show losses in multiple years are subject to review for actual profit motivation under the hobby loss rules, which the IRS can and does audit regularly. Just because you love making arts and crafts project in the garage or enjoy racing cars on the weekend does not mean that you are engaging in these activities with the motivation of making a profit. The IRS knows this and DIF score may increase especially with a for side businesses with an element of fun in them (travel writer, beer/wine making, horse racing, any sort of professional gambling, etc…) The IRS has been onto this trick for several years now and will audit businesses that show losses or that have the appearance of trying to off-set legitimate tax liability.
IRS audit risk in frequent stock trades and complex schedule D and B transactions
I hate to say there is a bias against those who trade stock, but frequent stock trading has a very high margin of reporting error and might earn you a review of your tax return by the IRS. There is nothing wrong with frequent trading and a good tax preparer can actually make the reporting pretty straight forward (many brokerages have gotten a lot better with the information contained in their statements. However, because of the complexity that occurs from some transactions or the difficulty in properly calculating basis for stock trades (and therefore appropriate gain and loss), the IRS sometimes will want to take a second look at your return to make sure this have been done accurately. However, these issues are often time consuming and difficult, so I personally have not see too many returns subjected to an IRS audit on the basis of stock trading alone unless there is a mistake on the return.
A word to the wise for traders though. I hope that if you are dealing in frequent trades or asset sales that you have a tax attorney, CPA, or someone else knowledgeable to prepare your returns. Although mistakes can and do happen, they are significantly reduced hire a preparer comparable to the level of sophistication of the tax return. In most cases, if you follow this rule, you should be fine. However, make sure especially in this instance to save all documentation relating to any stock trades or the sales of that asset (especially how you valued it). This will make or break you should you have to undergo an IRS audit.
Continue to IRS Audit Red Flags – Part Nine – Margins