Schedule C Audit: Expenses the IRS Questions and Proof to Keep

How do other small businesses seem to deduct everything?

No one can deduct everything. Every Schedule C expense must be ordinary and necessary for the business, not personal, and provable (Publication 334; section 162). An owner who seems to deduct everything may have different real costs, a year no one has examined yet, or personal costs counted as business. Legal ways to pay less tax are in lowering your business tax.

The lines that ask for more than a bank statement are car and truck, travel and meals, home office, contract labor, equipment and large "other" totals. The proof each needs is below, though none of the IRS pages cited here ranks the lines.

A return that was never audited has not been approved. The IRS can generally include returns filed in the last three years in an audit, may add years if it finds a substantial error, and usually does not go back more than six (IRS audits). By statute, the time to assess tax is generally three years after filing, six if more than 25% of gross income was left off, and unlimited if no return was filed or the return was fraudulent (section 6501).

Your case is not simple if car, home office or "other" expenses are large, expenses run high against income, business and personal money are mixed, years went unfiled, or an IRS letter has arrived. If a letter has already arrived, start with how an IRS audit of a small business runs. Gather first:

• Statements for every business account and card
• Receipts or invoices sorted by Schedule C line
• A mileage log
• The square footage of your home and of the work space
• Every Form 1099 you received or issued

What makes a Schedule C expense deductible?

An expense is deductible when it is ordinary, necessary, paid or incurred for your business in that year, and not personal (section 162(a); section 262).

Fines and penalties paid to a government for breaking a law are not deductible (Schedule C instructions).

How do I prove an expense is business related?

Keep three things for each expense: proof you paid, a document showing what it was, and the business reason. The burden of proof is yours, and you generally need documentary evidence such as receipts, canceled checks or bills (IRS burden of proof).

• Proof of payment: a canceled check, or an account statement showing the amount, the payee and the date it posted. Payment alone does not establish a deduction (Publication 583).
• What it was: an invoice, receipt or sales slip showing the amount and that the cost was for the business.
• Why it was business: a note made at the time, when the purpose is not obvious from the item, such as who attended a meal and what it was about.

Travel, gift and car expenses have stricter rules, below. See IRS receipt requirements for what a valid receipt shows, record keeping for self-employed for a year-round system and cash purchases, and lost receipts for business expenses if receipts are gone.

How does the IRS pick a Schedule C return for audit, and are some categories scrutinized more closely?

The IRS pages cited here do not list the expense types it audits. They describe these ways a return is chosen (IRS audits; Publication 556, an older edition):

• Computer screening and random sample. Returns are compared with "norms" for similar returns, and some are chosen by a statistical formula alone.
• Document matching. Income on Forms 1099 or W-2 that does not match the return.
• A questionable item. A return may be chosen to address how an item was treated and to study how similar taxpayers handle the same tax issue.
• Related examinations and other information. The return involves a partner, investor or other taxpayer whose return was selected, or the IRS received outside information, which it evaluates for reliability first.

Selection does not mean there is an error, and Publication 556 says many examinations end with a refund or with the return accepted unchanged. Neither page says which lines or amounts the comparison weighs, so a list of "red flag" lines is a guess, not an IRS finding.

The IRS also publishes Audit Techniques Guides for examiners, mostly by industry, including one on activities not engaged in for profit. If your industry has one, it describes the issues common in that industry's audits. An audit begins by mail with a written request for specific documents; see how an IRS audit of a small business runs.

Which Schedule C lines draw the most questions, and what proves each one?

These are the lines where the law asks for more than a bank statement, or where business and personal use mix.

Sources: Schedule C and its instructions; Publication 463; Publication 587. Line numbers follow the latest published Schedule C; lines can move from year to year, so check the form you file.

What proof do car, travel and meal expenses need?

For travel, gifts and listed property such as a passenger car, no deduction is allowed unless you prove, with adequate records or other evidence that backs up your own statement, the amount, the time and place of travel (or the date and description of a gift), the business purpose and, for a gift, the business relationship of the person who received it (section 274(d)). Estimates and unsupported statements do not count (26 CFR 1.274-5T; Publication 463).

• Car. For each business use: date, destination, purpose and miles, plus the car's total miles for the year. Driving between home and a regular work location is commuting and not deductible; driving from a home that is your principal place of business to another work location in the same business is not commuting (Schedule C instructions).
• Travel. Travel away from home means a trip outside the general area of your tax home (your main place of business, wherever your family lives) that is substantially longer than an ordinary day's work and needs sleep or rest. For each such trip, keep the cost of each expense, the dates you left and returned, the destination and the business purpose. Keep a receipt for lodging and for any other expense of $75 or more; a transportation receipt that is not readily available is excused. If you use the standard meal allowance for meals on the trip, you do not keep the actual cost of those meals, but you still keep records of the time, place and business purpose of the trip (Schedule C instructions; Publication 463).
• Meals. In most cases only 50% is deductible, and entertainment is generally not deductible (section 274; Schedule C instructions). Business meals also have conditions on who is present, who the meal is for and whether it is lavish. Record the date, place, business purpose and who attended; a restaurant receipt should show the name and location, the number of people, the date and the amount (Publication 463).

A log kept at the time is not required, but a record made at or near the time and backed by documents carries far more weight than a statement prepared later. A log kept for part of the year can support the year's business-use share if other evidence shows that period was representative (26 CFR 1.274-5T; Publication 463).

Details: mileage log requirements, standard mileage or actual car expenses, business meals deduction. If no log was kept, see rebuilding a mileage log.

What does the home office deduction require?

Part of your home must be used regularly and exclusively for business, and it must be your principal place of business, a place where you meet clients, or a separate structure (Publication 587; section 280A(c)(1)).

• Exclusive and regular: a specific area used only for the business, on a regular basis. It can be a room or a separately identifiable space with no permanent partition. Any personal use of the same area fails the test, except that space used to store inventory or product samples, and daycare space, have their own rules. Incidental or occasional business use is not regular use.
• Principal place of business: the IRS weighs the relative importance of the work done at each place and the time spent there. A home office also qualifies if you use it exclusively and regularly for administrative or management work and have no other fixed place where you do substantial administrative or management work.

An income limit also applies. With actual expenses, utilities, insurance, depreciation and similar costs cannot exceed the business's income from the home after subtracting the home's mortgage interest and real estate taxes and the business's other expenses; Form 8829 carries the excess forward (Publication 587; section 280A(c)(5)). The simplified method has its own limit and does not relax the qualifying tests (Schedule C instructions). Records must show the part of the home used and its regular and exclusive use; with actual expenses they must also show the expenses and depreciation for that part. To choose a method, see home office: simplified or actual.

What if an expense is partly personal?

For an expense used for both business and personal purposes, deduct only the business part, split on a basis you can show. The personal part is generally not deductible (Publication 334).

• A car is split by miles driven for business and for personal use (Publication 463).
• A home is split by area, the business space compared with the whole home. An area used for both business and personal purposes generally does not qualify (Publication 587).

Personal bills paid from a business account must be separated in the books. See personal expenses paid from the business account and fixing commingled business and personal funds.

My expenses are high against my income, or I have a loss: what does the IRS look at?

High expenses are allowed when each one is ordinary, necessary, business and provable. The IRS compares returns with "norms" for similar returns (IRS audits) but the pages cited here do not give them, so each line needs its own support. When expenses exceed income, the IRS also looks at whether the activity is a business run to make a profit. A business has a primary purpose of income or profit and is carried on with continuity and regularity; a hobby does not qualify (Schedule C instructions). If an activity is not engaged in for profit, its loss cannot offset other income, and its income is still reportable; its expenses are generally not deductible at all, because the deduction section 183 allows for them is a miscellaneous itemized deduction, which section 67 now disallows (IRS hobby fact sheet; section 67; section 183).

By statute, an activity with a profit in 3 or more of 5 consecutive years (2 of 7 for an activity that is mostly breeding, training, showing or racing horses) is presumed to be for profit unless the IRS shows otherwise. Missing that presumption does not make an activity a hobby; the IRS weighs the facts, including whether complete books are kept, whether methods change to improve profitability, and whether losses continue past the period needed to reach a profit (IRS hobby fact sheet). A new activity can elect, on Form 5213, to delay the presumption test until the close of the fifth year of the activity (the seventh for horses). File it within three years after the unextended due date of the first year's return, or within 60 days after a written IRS notice proposing to disallow the deductions, if sooner; on a joint return both spouses elect. It generally extends the time to assess tax on the activity to two years after the unextended due date of the last return in that period (Form 5213; section 183(e)).

Separate rules can also limit a real business's loss: limits tied to how much you have at risk, how much you took part in running the business, and a yearly cap on total business losses (Schedule C lines G and 32, and Form 461). For the full list of hobby questions and these loss limits, see business losses. For online resellers, see hobby or business.

What happens if the IRS disallows an expense?

If the IRS disallows an expense, your net profit rises by that amount. The net profit on line 31 flows to both Schedule 1 and Schedule SE, so income tax and self-employment tax can both rise (Schedule C instructions). On top of that:

• Accuracy-related penalty: 20% of the part of the underpayment due to negligence or disregard of the rules, or to a substantial understatement (IRS accuracy-related penalty; section 6662). Negligence includes failing to keep adequate books and records or to substantiate items properly (26 CFR 1.6662-3). For an individual, an understatement is substantial when it exceeds the greater of 10% of the correct tax or $5,000; the share is 5% if the return claims the section 199A qualified business income deduction. The IRS may reduce a penalty if you acted in good faith and can show reasonable cause.
• Interest: it runs on the tax from the return's due date and on an accuracy-related penalty from the due date, or the extended due date if an extension was filed, at a rate that can change each quarter (IRS interest; section 6601(e)(2)(B)).
• Fraud: if the IRS establishes that part of an underpayment is due to fraud, a separate penalty of 75% applies to the whole underpayment except the part you prove is not due to fraud, instead of the accuracy-related penalty (section 6663; section 6662(b)).

An audit ends with no change, agreed changes, or changes you disagree with and can appeal (IRS audits). For more on interest and penalties, see how an IRS audit of a small business runs. For a return already filed with expense mistakes, see amending a return for business expense mistakes.

What should I check on each line before I file?

1. Every deduction ties to supporting records. Match bank and card payments to statements and receipts or invoices, cash purchases to a receipt or a note made at the time, and calculated deductions (mileage, depreciation, simplified home office) to their logs or worksheets. Household costs are out; split mixed items by miles, area or another basis you can show.
2. Car, travel, meals and home (lines 9, 24a, 24b and 30). The records match the table above: business, commuting and other miles add up to total miles; trips and meals are logged by date, place and purpose; meals are at the allowed share with entertainment excluded; the home space is measured and used only for business and regularly; and the Part IV (or Form 4562, Part V) answers about evidence are true.
3. Other expenses, line 48. Each is listed by type and amount, equipment is in depreciation or a documented safe-harbor election, and no fines or penalties are included.
4. Forms 1099 and loss. Lines I and J are answered correctly, every Form 1099 you received ties to gross receipts, and a loss is backed by books that show a profit effort.

Example

These examples are illustrative; the figures are in US dollars.

Car costs with no log

A consultant with US$90,000 of revenue deducts US$12,000 of actual car and truck costs as fully business use, with no log. A passenger car is listed property, so the deduction needs the date, destination, purpose and miles of each business use and the car's total miles, not an estimate. A record rebuilt later needs strong corroborating documents, such as calendar entries and client invoices. If the rebuilt record shows 12,000 business miles out of 20,000 total, business use would be 60%, so at most about US$7,200 of the costs could be business, and only to the extent the records hold up; the other US$4,800 is personal. With the standard mileage rate, the deduction is instead business miles times the IRS rate, plus parking and tolls, and the same records are needed. Business use above 50% is also what lets a car use accelerated depreciation or a section 179 deduction; a later drop to 50% or less brings earlier excess depreciation back into income (Publication 463).

A desk in the living room

A designer deducts US$6,000 of home expenses for an "office" that is a desk in the family living room. If the family also uses the space, it fails the exclusive-use test and the deduction can be denied. If a defined corner is used only for work and used regularly, the business share is that corner's area compared with the whole home, not the whole room's.

Three years of losses

An online seller has US$20,000 of revenue and US$30,000 of expenses for the third year in a row, a loss each year. Three loss years in a row mean the profit presumption is not met, so the IRS may ask whether the activity is run to make a profit. Complete books and changes to improve results support a yes; losses that go on past the time needed to reach a profit point the other way. If this is the activity's third year, the Form 5213 election above may still be open. If it is a hobby, the US$20,000 is still reportable and the expenses are generally not deductible against it, so the loss cannot offset other income.

Different for you?

These situations go beyond the rules above, because the answer depends on your own records:

• You are deducting a large car, home office or other-expense total, and the records are thin: support may need to be rebuilt line by line before a return is filed or a letter answered. See lost receipts, rebuilding a mileage log and bookkeeping help.
• Your expenses run high against income, or you have a loss: complete books and records are one of the questions the profit test asks. See business losses and bookkeeping help.
• An IRS notice has arrived: see how an IRS audit of a small business runs and what to do with an IRS notice to your business. Matching records to each line is bookkeeping work: bookkeeping help.
• A filed year has expenses you now doubt: see amending a return for business expense mistakes. Reviewing the records behind the doubt is bookkeeping work: bookkeeping help.
• Years were never filed, or the books are behind: see Schedule C expenses for unfiled years, catching up on overdue books and penalties for not keeping business records. Missed years usually need books rebuilt from statements and records before a return can be prepared: bookkeeping help.
• You or the business are partly outside the US: see nonresident return for business income.