Tax Tip Tuesday: Schedule C Red Flags That Trigger IRS Reviews

A fashion designer records herself in a home studio while working on new designs, highlighting the self-employed lifestyle relevant to Schedule C tax reporting.

If you're a freelancer, sole proprietor, or small business owner, filing Schedule C with your tax return is part of your routine. But it’s important to know that some entries on that form can raise questions with the IRS. While most small businesses won’t face an audit, certain red flags can increase your chances of receiving IRS correspondence, a notice, or a closer look at your return.

At MKHS Tax Group, we focus on helping taxpayers stay compliant while taking advantage of every deduction they're entitled to. Here are some common Schedule C red flags that can trigger IRS attention—and how to avoid them through sound record keeping and good tax hygiene.

One major red flag is high expenses relative to income, especially if your business is showing a net loss year after year. If the IRS sees that your business hasn’t turned a profit in at least three of five consecutive years, they may classify it as a hobby rather than a business. That means you could lose the ability to deduct those expenses. Let’s say you’re a self-employed graphic designer consistently reporting $40,000 in revenue but $45,000 in expenses, year after year. Even if those numbers are legitimate, you may need to demonstrate your intent to run a for-profit operation, backed by proper documentation and a clear business strategy.

Another area the IRS reviews carefully is the home office deduction. This deduction is entirely valid for those who use a dedicated area of their home exclusively and regularly for business. But problems arise when the deduction seems excessive—for example, claiming that 50% of your home is used for business—or when the space serves dual purposes, like doubling as a guest room. The IRS expects precision here. If you're using the simplified method (up to $1,500), it's easier to document, but you should still be ready to support your claim if asked.

Excessive meals and travel expenses can also attract attention. Meals are typically only 50% deductible, and travel has to be ordinary and necessary for your business. If you’re a consultant earning $50,000 and reporting $12,000 in meals and travel, that might stand out. The IRS wants to see that these deductions are directly tied to business activities, with supporting records like receipts, itineraries, and meeting notes. Keep a clear paper trail to show how those costs connect to income-producing work.

Vehicle deductions are another area with a high audit risk. The IRS often flags cases where the number of business miles seems excessive compared to the income reported. For example, claiming 25,000 business miles on $18,000 of revenue may raise questions. They’ll want to see mileage logs and whether the business activity supports that level of driving. Remember: estimates won’t cut it. Use apps or spreadsheets to track mileage consistently and accurately throughout the year.

Cash-heavy businesses, such as hair salons, cleaning services, or landscaping operations, also receive more scrutiny. The IRS knows these industries may underreport income, especially if they lack third-party reporting (like 1099s or credit card payments). If you receive a lot of cash, it's essential to document every payment and make regular deposits to a business account. Inconsistent deposits or minimal reported income may lead to an audit based on lifestyle or bank activity.

The distinction between a hobby and a true business also plays a role. The IRS uses several criteria to determine whether you're running a legitimate business. These include how much time you spend on the activity, whether you depend on the income, and whether you make adjustments to improve profitability. For example, if you sell handmade crafts but don’t track expenses or operate with a business plan, the IRS may question your profit motive. When a taxpayer is repeatedly showing losses without signs of active business management, that activity may be reclassified as a hobby, disqualifying those deductions.

Another common pitfall is the use of vague or excessive “Other Expenses.” This category on Schedule C is for valid costs not captured in other line items, but if the amount is large and the description is unclear—say, $20,000 listed simply as “miscellaneous”—that could prompt questions. The solution? Break these down into specific categories and provide clear labels such as “web development,” “independent contractor fees,” or “IT support.” This shows the IRS you’re being transparent and organized.

Mismatches between 1099 income and Schedule C entries are a straightforward trigger for IRS correspondence. If you receive 1099-NEC forms, the IRS expects to see that income reported in full. If a client issues you a 1099 for $30,000 and you only report $25,000 in gross receipts, the system will flag the difference. Always reconcile your 1099s with your books, and make sure nothing is missing—even if you think a 1099 is incorrect. It’s better to report the income and dispute it through the proper channels than to leave it off your return.

Another pattern that can raise eyebrows is the use of round numbers and estimates. Real-world expenses tend to have decimals and variability. If your return shows $5,000 for supplies, $10,000 for travel, and $15,000 for equipment—all with clean zeros—it could signal to the IRS that you’re estimating rather than reporting actual numbers. Good record keeping, including digital receipts and expense tracking tools, helps ensure accuracy and credibility.

Finally, repeated late filings or frequent amended returns may make the IRS more likely to take a closer look. Filing on time shows that you're organized and serious about compliance. While mistakes happen, amending returns every year or always filing on the last day of an extension might indicate larger problems in how you’re managing your tax responsibilities.

Most small businesses can file Schedule C without issue—but knowing what the IRS looks for can help you stay ahead of the curve. The key is consistency, documentation, and understanding how your numbers tell the story of your business. If you’re unsure whether your Schedule C might raise questions, a proactive review is the best move. For help, reach out to info@mkhstaxgroup.com—we’re happy to walk you through it.