Each year the IRS publishes their activities in a publication called the Data Book. And each year for the past number of years the number one target of audits are those tax returns with a Schedule C for small business activity. So how can you prepare yourself for a possible audit? Here are some tips.
- Keep records separate. The quickest way to get a business deduction disallowed is to blend your personal bills with those from your business. Instead, consider opening a separate checking account and use a separate credit card for business expenses.
- Keep logs. Keep a logbook for business miles, as well as business meetings and meals. Include the date, time, subject, and who was present at the meeting.
- Ordinary and necessary. Two key words to use to qualify legitimate, deductible business expenses per the IRS are:
- Ordinary: An expense that is common and accepted in your industry.
- Necessary: An expense that is helpful and appropriate for your business.
- Business not hobby. A qualified business activity allows for direct deductibility of appropriate expenses, whereas hobby activity expenses are generally disallowed. There are many facets to this situation, but to stay away from the hobby problem, you need to have a profit motive and active participation in the activity to qualify your activity as a business.
- The IRS will know. Starting in 2023, the IRS is requiring third-party payment providers to submit 1099-K forms for all activity over $600. This means if you take credit cards or use digital payment tools to accept payments from customers, the IRS is going to be looking for a business tax return. So keep good records!
Just because the IRS focuses their audit activities in this area does not mean you should be reluctant to take appropriate deductions. Just be prepared to defend your position with excellent records.