Liz Weston: Business owner who ‘cancels everything’ may face IRS audit

Dear Liz: I have a friend who drives me crazy because she keeps telling me I need to start a business.

She claims she is writing off “everything” from her two businesses and a nonprofit. She says her accountant encourages her and she doesn’t pay taxes.

However, when my friend had to claim unemployment benefits during the pandemic, her weekly amount was very low. She kept complaining that she had “contributed to the system”, but thought she should receive a higher amount. Maybe she hasn’t paid into the system or isn’t paying enough?

Answer: People who write off “everything” often commit tax evasion. Although businesses can deduct a number of different expenses, these expenses must be both “ordinary” – common and accepted in the specific business sector – and “necessary”, or useful and appropriate for that business or particular trade.

Nonprofits, as defined by the IRS, are meant to be organized and operated exclusively for religious, educational, or charitable purposes — not for the benefit of any single individual.

Your friend could face a substantial tax bill and heavy penalties if she is audited. She may be counting on the IRS not noticing, but all it takes to trigger an audit is a tip from a disgruntled employee or someone who hears her bragging about do not pay taxes. If his accountant has a history of filing questionable returns, the IRS might figure out the pattern and start taking a closer look at all of that accountant’s clients.

Your friend’s strategy of minimizing her taxable income has already bitten her once when she filed for unemployment and may bite her again when she files for Social Security. If she pays no social security contributions, or only pays a small amount, her retirement benefits will reflect this. By the time many people realize the enormity of this particular error, it is too late to fix it.

Liz Weston, Certified Financial Planner, is a personal finance columnist for Nerd Wallet. Questions can be sent to him at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.

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