Home Office Deduction for Schedule C IRS Red Flag

Home Office Deduction for Schedule C IRS Red Flag

Disclaimer: While striving for accuracy, the writer is not a tax professional. As always, readers should consult a tax professional for tax advice.

Filing a Schedule C, Business Profit or Loss, increases a filer’s chance of being audited, according to Bernard S. Kent, co-author of “Price Waterhouse Coopers Guide to the 2005 Tax Rules,” and is among the items that trigger closer inspection (red flags), according to the Internal Revenue Service (IRS).

Schedule C filers are the group most likely to be audited, according to Kent. The IRS says that this higher rate of audits is because many of the taxpayers who file Schedule C forms are trying to deduct hobby losses and call them business expenses. The IRS makes it clear on the Form Schedule C and on the instructions for the form that hobby expenses or hobby losses are not allowable deductions.

Underground Economy Concerns IRS

Unreported income and off the books transactions fuel the “underground economy” in the United States, and it concerns the Internal Revenue Service. Robert P. Brennan, a former IRS agent turned accounting consultant, told Andrea Coombes of the Wall Street Journal’s Market Watch for its April 13, 2009 edition, that about $290 billion in income goes unreported each year.

Much of that unreported income is believed to be from Schedule C filers, and that’s the reason for the closer scrutiny. The IRS wants to catch those who would cheat on their taxes by not reporting income or attempting to deduct disallowed expenses.

Increase Risk of IRS Audit

The chance of being audited for most individuals is small – the IRS claims in its publications that agents only audit approximately 2% (or less) of each year’s tax returns. Information from years 2006 and 2007 indicates that audits are increasing. For some tax brackets and categories of filers, the audit rate is as high as 29%, according to Kent.

Some business owners believe that filing a Schedule C or taking the home office deduction (business use of home) does increase chances of being audited. In-home daycare providers don’t have a choice; they must file a Schedule C.

Some taxpayers may come to the conclusion that it’s not worth the risk, and will not take the deduction even though they may qualify. Some will decide that the value of the tax benefit outweighs the risk. Tax professionals say that the thought of being audited shouldn’t keep a business owner from taking a legitimate deduction, but they should be sure they can prove it is a legitimate deduction.