Every year, American taxpayers underpay by approximately $440 billion or more. This is called the “tax gap.”
How should the IRS address the tax gap? Although the IRS’s audit priorities remain secret, there are indications that the agency focuses on certain types of tax claims that are easy to fudge. This year, the Treasury Inspector General for Tax Administration (TIGTA), the IRS’s watchdog, has recommended focusing audits on taxpayers who report significant losses on Schedule C of their Form 1040.
That’s unfortunate for many taxpayers who have actually suffered significant business losses during 2020. As you know, the losses from the Coronavirus lockdowns and other events have been severe for many small businesses.
Schedule C of Form 1040 is the place for very small businesses to report their business activities. These include sole proprietors and single-member limited liability companies, for example.
One reason TIGTA thinks auditing Schedule C losses would be valuable is that there are limited third-party checks on these claims. The IRS can’t easily cross-reference the deductions on Schedule C without an audit, as it can when matching up W-2s and W-4s.
The abuses may be real. According to Forbes, the IRS estimates net misreporting on Schedule C to be as high as 55% in cases where there is little cross-referencing information to be had. The agency estimates that underreporting contributes about $352 billion to the tax gap annually, and that as much as 45% of this underreporting is associated with Schedule C.
In any case, the courts may view repeated, significant Schedule C losses as evidence of tax fraud.
In recommending the audits of Schedule C losses, TIGTA hopes to help combat repeat noncompliance.
Moreover, TIGTA estimates that focusing in on Schedule Cs that reflect no profit but a loss of $100,000 or greater could bring in assessments of $50,000 or more. That’s a significant return on investment for audits.
Overall, TIGTA says that the IRS has failed to audit Schedule C losses adequately in the past. There is a compliance risk and an opportunity to realize a high return on audit investment.
Is your Schedule C in the target zone?
It is if you’ve claimed no gross receipts and no profit on your Schedule C and your return reflects a loss of $100,000 or more. There may not be much you can do to avoid an audit if you actually lost that amount in 2020. However, you should hire a tax attorney to protect your rights during the audit.
If your Schedule C losses met those criteria in past years and may not have been completely accurate, you may wish to consider a preemptive voluntary disclosure or amended return.