how does the IRS decide who to audit?
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Is it the meal expenses or the auto expenses…. or is it that trip to Bali that you took with your family that you wrote off as a travel expense?!
All jokes aside, how does the IRS decide who to audit? 🤔
In the days of "big data," the IRS uses an algorithm to measure all kinds of data on your tax return, and compare it to others'. The IRS knows your field, and they know what a "normal" range of expenses is on any given category on your tax return. So, when your numbers pop out of that normal range, your tax return gets a flag.
It's all automated.
In this week's podcast episode, I'm talking about the fascinating way that the IRS identifies taxpayers for audit. And how you can see what they're seeing, and keep yourself protected.
I'm also teaching you which category on your deductions is actually beneficial to you and which categories you should not treat as a "dumping ground".
It is a little tax-nerdy, but very interesting, and will keep you protected.
Podcast Transcript:
Today I am super excited to bring you a little bit of detail about your tax deductions. In case you’re new here, this podcast episode was shared with my email list first. If you want help making informed decisions, but better, with all the tax and bookkeeping skills that school never taught you. Sign up for tax tips, bookkeeping advice, and general biz knowledge to keep you growing using the link in the show notes in this podcast episode.
Over the years i have come to learn alot about specifics in the categories inside of your deductions and some of them are interesting and give you some of the strategy of what to stress over and what not to stress over when it comes to taking your deductions for your small business.
When it comes to your business, there are basically a whole bunch of different categories of deductions, and essentially your goal is to document those deductions all through the year the way that the IRS requires.
but your tax return is only going to have the totals in each category. So The irs can go back and they could ask you to show them more details on anything and everything in those categories. At which point you'll want to show them the bookkeeping that showed everything inside. for example on the tax return itself, think of it more like the cliff notes whereas your bookkeeping where you have every transaction is the whole novel itself. The IRS can come and audit you and ask to read a chapter and you will have to provide a chapter, and here in my analogy your chapter are your receipts, possibly your bank statements and maybe some of your bookkeeping.
Today I want to talk to you about a few key interesting areas when it comes to these deductions and give you a little extra guidance at the end. The first category I want to talk about is advertising. Now advertising is one of the what i call, golden categories, and the reason for that is that advertising itself is proof that you are operating a business and not a hobby. hobbyist in general don't advertise, and one of the key tricky issues that a lot of business owners face especially in the creative industries, alot of times it struggles to turn a profit even though you are really genuinely trying to make a business out of it and genuinely have a profit motive. So advertising, a lot of people don't realize this, advertising in the signal in your profit motive. The irs definition of when your business begins is the moment you first advertise. If you think of it, advertising is your signal to the world that you are open for business right, that whatever you have for sale, products, services, etc.. is available. Right, so advertising is a beneficial category. It is a category that actually sort of is, a positive for you. In general, strategically, when i am doing a tax return there can be some confusion sometimes of whether you put somethings in one category vs another, i think some people stress about that a little too much but i will say that if there is ever any confusion about if something is in one of two categories and one of the categories could legitimately be advertising, i'd put it in advertising. For example, your website, or your website hosting fees that's an advertising expense! your website is a key piece to advertising. i don't put that in office supplies or some other part of your tax return, I always pull that one out and put it into advertising. Especially when a person is struggling to make a profit and stay on the good side of the hobby loss rule where the irs assumes that you have a business and not a hobby. I am always trying to bulk up the category that really is proof of running a business. It seems so small but I thought I would share it.
Now, There are two expenses on the tax return that can tend to be a dumping ground, this can happen with lazy accountants, i see it all the time and i say that because when someone does your taxes they see the work of the last person who did your taxes, that's one of the deals, so i'm always seeing other tax preparers or whenever a client comes to me with last years tax return, right so i see it all the time, that accountants, sometimes clients, but actually more often busy accountants who just try to run through a lot of tax returns quickly that they will just dump stuff in certain categories. And these two sort of typical dumping ground categories are office expenses and other expenses.
Now, office expenses is actually attracted a little bit of scrutiny under the law for this reason. i know ny state has actually passed some laws around the office expenses category some time ago, i dont remember what they are at this point but the caution is basically just dont put anything that you don't understand what it is into the category of office expense, actually go back and ask your client what this thing is and put it in the right place. Apparently ny state was seeing a lot of tax preparers dump stuff into that category so ny was going through and making a practice of auditing tax returns where that has happened to see if there was some stuff in that category that maybe didn't belong there or that should not have been on the tax return at all.
Now a related but slightly different category is called other expenses and I have something kind of interesting to share with you about the other expense category. So other expenses is sort of a catch all category that comes at the end of the rest of your deductions and it's an unnamed category and it's essentially for expenses that don't fit in another place. You might have deductible expenses that are perfectly legitimate but there isn't a specific holed out category that they would fit into.
Somethings that i might put in the line other expenses are research expenses, education expenses, professional development expenses and occasionally a large line item that is too big to fit in office supplies, I would also put postage expenses in there as well. That would typically be when you ship your products, you know that when you have to ship your products it can get quite expensive and its more than an office who just sends paper or envelopes in the mail, you are sending crates with massive amounts of insurance so that's quite a different category of expense.
I heard this interesting thing that the irs computers actually cannot see exactly what is in the other expense category, the computer itself is only scanning what the total number is. But if that number is out of line, if it's really really high, especially really high with a lot of blanks in the other parts of the return, sometimes the irs will turn around and ask the client, the taxpayer, to show them what is in that category, so in other words they cannot actually see on your tax return what's in your other expense category so sometimes strategically you don't want to use the other expense category as a dumping ground and put a lot of stuff there because if that line item becomes too out of proportion with your other deductions you may get an audit simply because the irs cannot see what you have in there.
That is an insider tip on something, maybe to try to avoid on your return. In general you want to do the best job that you can, putting your expenses in the proper category where they belong and being specific, now, you don't need to have 50 line items on the other expense category and please don't, but you know, everything that is a professional development expense, you can put together in one line item, everything that is a postage expense, you can put together in one line item, please do not pull them out individually. That will be a headache and a lot of work for everyone involved.
Now i want to tell you one last key interesting thing about how tax returns get flagged for audit. So on your business return there is a code at the top that's called a naics(Nakes) code, i don't remember what it stands for but basically its an industry code, it basically identifies what industry your business is in. but what happens is, you identify with the naics(Nakes) code what field you are in and if you think about it, the irs has all the data from every single tax return, every single schedule c across the entire US tax paying population.
and they run what they call a diff score. It's a differential, so they basically determine what a reasonable range is for each naics(Nakes) code. Each industry. So they know for every single category on your schedule c, they know what the low and high range are for that category, they know if you are a real estate agent in texas, they know the range of travel expenses or meal expenses that are within a normal limit and these are actually something you can look up online, which is fascinating to read.
But essentially the way that flags happen on a tax return is if your expenses on a category falls above the range, higher than a typical person with your income level with your naics(Nakes) code, you my friend will likely get a flag put on your tax return.
Now, not every tax return that is flagged will be audited but all of the audits come from the flags. So having extremely outsized expenses in a single category are a really good way to get audited.
Now something that i often end up having conversations with clients is, there are times where you might really have expenses in a certain category that are extremely high because of the nature of the work you do, you might legitimately be on the really high range on that expense in your area in your field.
Now of course the moment you know if the irs were to audit that category and you would have to prove it, you'll just show them your work, your expenses, making it obvious that it is real and a necessary expense of your work. What I recommend is that if you know that you have something that is a little unusual in your industry, just document it really well. You want to be extra safe and buttoned up because the chances are just a little higher that the IRS may someday come, turn around and ask you to prove those expenses. The good thing is an audit is a check up, not an accusation so if you show them the documentation that you need you will be fine.
So in that I will talk to you all next week!
