The moment you dreaded is here: The IRS is going to audit your home-based business. Will the IRS disallow your home-office deduction?
Before you panic, take the following steps.
Step 1. Know what to expect
What will happen during an audit? First, note that the IRS only alerts you of audits by mail — not by phone or email. Actual audits are conducted either by mail or in person at an IRS office or your office. Depending on where your audit takes place, you'll need to either mail in copies of the requested documents, bring them to the IRS office or have them available at your office.
Step 2. Talk to your tax preparer
You have 30 days to respond to the IRS notice. Before you respond, let your tax preparer know that you are being audited. He or she may want to respond to the IRS on your behalf and/or represent you at the audit. At a minimum, he or she can help you organize your records and prepare for the audit. If you prepared your taxes, it's worth retaining a CPA or other qualified tax preparer who can advise you.
Step 3. Organize your records
During an audit, the IRS agent may request business records for the past three years. If there is a concern about back taxes, the IRS may request records for the past 10 years. Make sure that your business records, both digital and paper, are in order so you're ready to produce any documents the auditor may request. Showing that your records are well-organized will also help support your use of the home office for business.
Just as you separate your business and personal bank accounts, it's also important to separate your business and personal files. While you might normally have some personal files among your business files in a regular office, in a home office this could be a red flag.
Step 4. Prepare your home office
During an audit, the auditor will want to see that your home office meets the criteria for the home office deduction. This means it must be your principal place of business and be used regularly and exclusively for business purposes. You cannot use it for business only occasionally while doing most of your work at another location. You cannot use it for business during the day and your children's homework station at night.
Some obvious red flags will alert an auditor that your home office doesn't meet the IRS criteria for the home-office deduction. For instance, if you have a bed in the office because it doubles as a guest room when visitors come to town, you're using the office for personal purposes as well as business. In this case, you may be able to justify the deduction by separating the guest room section of the room from the office section. For example, you could use folding screens or bookcases to partition off your office and deduct only the square footage used as an office.
When it comes to a home-office audit, you can't be too careful. To be safe, it's best to remove from your office any personal photos, knickknacks, books, or other items that might be construed as personal, even if they are things you’d normally have in a regular office.
The equipment in your home office can also get you in trouble during an audit. For example, if you have a printer in your home office and there's no other printer anywhere in your house, the agent will find it hard to believe that you never use that printer for anything personal. Likewise, remove television sets, stereos, or anything else that may seem like a personal item, even if you actually do use them for business. Is there a closet in your home office? Make sure there are no personal items or clothing inside.
If you're mailing your supporting documents or being audited at an IRS office, it's a good idea to take several photos of your office to show the auditor the layout.
Whether the audit takes place in your home office or elsewhere, the steps above may help improve your chances of surviving a home-office audit.
For more about the home-office deduction, see Publication 587, Business Use of Your Home.