Due to the changing nature of taxation law, you should double-check all the suggestions provided in this article with your professional accountant. This information is not intended as professional advice. Neither Rachel, nor SitePoint, is a tax expert.
You probably aren’t too concerned about being selected for an audit. Well, if you’re a freelancer, avoiding an audit should always be on your mind as you file your taxes. Why? Because, no matter how straight you play it, freelancers get audited much more than salaried employees do. No – the United States IRS doesn’t have it in for independents, but the numerous deductions that we file set us apart from other taxpayers.
So what can you do to keep the IRS from noticing your return? Below find hints and suggestions to keep the IRS away! These tips are particularly relevant to those in the US, though other tax systems may be similar — check with your accountant for details. And please note that the information provided here should by no means be used as a guide to filing your taxes! These are merely suggested tips and hints. Be sure to seek professional advice in taxation, as in all business matters.
Six Steps to an Audit-Free Tax Return
1. Be Careful With Deductions
The IRS’s favorite target is the home office deduction. In order to qualify for a home office deduction, your office needs to be your "principal place of business" and used "regularly and exclusively" for business. In plain language, this means that your home office needs to be the place where you spend most of your time and make the majority of your income.
You’ll also need to keep your personal life out of your home office. For example: a trick that I heard the IRS sometimes uses is to ask the taxpayer being audited "Do you use your computer for 50% personal and 50% business or 5% personal and 95% business?" If you answer 95% business, you have flunked the test — the answer needs to be 100% business. This example demonstrates the strict enforcement of the guidelines for the home office deduction. We’ll talk about this more in Home Office Deductions for Freelancers.
You also need to keep other deductions that you want to take to a reasonable level. Keep a receipt for all deductible expenses, especially food, entertainment, travel, and automobile costs. These are often the deductibles that are most scrutinized by the IRS. You should also keep expenses in a log, along the following information:
- The name and location of the expense
- Amount paid
- Date and time
- Company the expense was incurred for
- If an entertainment or food expense: the person you entertained or dined
- If an entertainment or food expense: the discussion you had
2. Where You Live Vs. Your Income
If you live in a very high-income area, but you only claimed that you earned $15,000 that year, this is a red flag for an audit. The IRS will want to know how you spread $15,000 out to pay all your bills. Unless you live with your mother who pays the mortgage or rent, there’s no way that you could survive in Aspen on this income… and the IRS knows it!
Also, if your income is much lower than last year’s taxable income, this IRS will wonder where you’re hiding the money, and will want to investigate.
3. Avoid Inconsistencies
If there are inconsistencies, the IRS will catch them. Be sure to file the same information on your federal taxes that you filed on your state returns.
4. Don’t Make Mathematical Mistakes
If the IRS’s computer system catches mathematical mistakes on your forms, a person will take a look at your returns personally. This is more attention than anyone wants spent on their tax forms, so make sure your math is correct before you file.
5. File a Neat Return
I recommend typing up or "efiling" your returns. If your returns are hard to read, you might have to translate your returns over the phone or in person.
6. Report All Your Income
It sounds like common sense, but some people are tempted to be dishonest. Your clients must issue you and the IRS a 1099 when you are paid over $600. This means that the government knows what you were paid on each job. Report the right amount on your taxes to avoid an audit.
Home Office Deductions for Freelancers
Home office deductions are one of the perks of working from home, however, there are clear drawbacks, too. If you meet the IRS guidelines for deducting your home office, you can expect to get a hefty tax break. On the other hand, deducting your home office can increase your chances of an audit. Additionally, if you claim your home office, you may incur additional taxes when you sell your home. Let’s take a look at the ins and outs of home office deductions.
The IRS Guidelines
Is your home office your "principal place of business"? Is your office used "regularly and exclusively" for business? The above questions must be answered with a "yes" if you want to meet IRS guidelines for deducting your home office.
"Principal Place Of Business"
How do you know if your office can be determined as your principal place of business? Well, do you spend most of your time and make the majority of your income from your home office?
If you work onsite at a client’s office the majority of the time, then you probably aren’t eligible. On the other hand, if you perform all your daily tasks from your home office, you probably are eligible. However, if you’re offsite for the majority of the day, but perform predominantly administrative activities from your home office, you may still be eligible. You cannot perform these administrative activities anywhere else but from your home office.
"Regularly and Exclusively"
You must use your home office regularly and exclusively. Your office doesn’t need to be a separate room, but it does need to be used "regularly and exclusively" for business.
This means that you need to keep all family activities and items away from your office. Keep your children off of your computer and your personal mail off of your desk, amongst other things.
Additionally, if you have more than one business, you cannot use your home office for your other business. For example, if you are a salaried Web designer, you cannot work on projects from your salaried job in your home office.
If You’re Eligible
You have decided that you are eligible for a home office deduction. Now what? I would contact an accountant and make sure that you have made the right decision. Then:
- Measure square footage of your entire home.
- Measure square footage of your home office.
- Divide office’s square footage by your home office’s square footage.
- This number is your percentage. Apply this percentage to indirect expenses, like your mortgage taxes, utility bills, real estate taxes, and upkeep. You can deduct a percentage of home-related expenses based on the percentage of space in your home that your home office takes up.So if your house is 5,000 square feet and your office is 500 square feet, you can deduct 10% from indirect expenses and home cost. Don’t worry, direct expenses are still deducted in full. For example, you wouldn’t use the percentage on things such as a business phone line.
- Find out home purchase price and add to that all home improvements.
- Find out the value of land.
- Find out the market value of your home.
The Cons of the Home Office Deduction
Yes, taking a home office deduction sounds like a great idea, but remember: there’s a downside too. If you deduct your home office, your office may be considered business property. This means that you will need to pay taxes on the amount by which the business depreciates when you sell your house. Because of this, a home office deduction might not be profitable for you. You might save a few hundred dollars every year with the home office deduction, but have to pay thousands of dollars when you sell the house. Because of this, I recommend you visit a tax accountant before you deduct a home office.
Another reason not to take the home office deduction is because the IRS might decide to audit your business when they see your home office deduction. Taking this deduction is like throwing a red flag in front of the IRS — keep this in mind as you decide whether or not to take the risk and deduct your home office.
Avoid the Audit!
If you follow the above guidelines, you have done everything that you can do to avoid an audit. As long as you keep your receipts, you’ll do fine if you are unlucky enough to get audited. Good Luck!
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