Every year, the Internal Revenue Service releases detailed statistics about who got audited the previous year.
The stats for 2011, covering 2010 returns — have recently come out and they paint an unpleasant picture for many real estate professionals — particularly the successful ones.
The percentage of business and nonbusiness returns that got audited in 2011 is shown in the following chart:
IRS Audit Rates (2010)
|Income under $25,000||1.3%|
|$25,000 to $100,000||2.9%|
|$100,000 to $200,000||4.3%|
|$200,000 and more||3.8%|
|Assets under $250,000||0.9%|
|$250,000 to $1 million||1.6%|
|$1 million to $5 million||1.9%|
|$5 million to $10 million||2.6%|
|$25,000 to $50,000||0.7%|
|$50,000 to $75,000||0.8%|
|$75,000 to $100,000||0.8%|
|$100,000 to $200,000||1.0%|
|$200,000 to $500,000||2.7%|
|$500,000 to $1 million||5.4%|
This chart shows that in 2010, 4.3 percent of sole proprietors earning $100,000 to $200,000 were audited. Not even corporations with assets worth between $5 million and $10 million were audited as often.
Moreover, only 1 percent of taxpayers who did not file a Schedule C form, but earned $100,000 to $200,000, were audited. Thus, self-employed taxpayers were four times as likely to be audited as employees earning the same amount.
In fact, employees earning as much as $500,000 were less likely to be audited than self-employed taxpayers earning as little as $100,000.
These statistics undoubtedly reflect the IRS’s belief that sole proprietors habitually underreport their income, take deductions to which they are not entitled, or otherwise cheat on their taxes.
Employees have less opportunity to cheat because their income tax is withheld by their employers and income reported directly to the IRS by them.
Unfortunately, most real estate professionals fall into the high-audit category: They are self-employed businesspeople who file Schedule C. The lesson these numbers teach is that you need to take the IRS seriously.
This doesn’t mean that you shouldn’t take all the deductions you’re legally entitled to take, but you should understand the rules and be able to back up the deductions you do take with proper records.
If you’re really worried about getting audited, think about forming a business entity to operate your real estate business. This could be a pass-through entity, such as a limited liability company taxed as a partnership or an S corporation.
Such entities don’t pay taxes themselves, but do file returns with the IRS. Both have extremely low audit rates: only 0.4 percent of such entities were audited in 2011. Regular C corporations also have relatively low audit rates.