A tax Audit occurs to about 1% of taxpayers. What triggers an IRS examination, or more commonly known as tax audit is generally something on the tax return that’s out of the ordinary. “For example, if you have a side hustle and file a Schedule C, the IRS will flag large losses, particularly if they offset other income. The IRS is looking to see if your activity is a hobby as opposed to a business.
Large charitable donations could also be a red flag. The IRS is stricter and it needs receipts to justify each deductible item. For safe measure, we ask our client if they have the receipts for the items donated and advise them accordingly to keep it in a filing folder.
Unreimbursed business expenses are another item we see people get flagged on. An important tip, if your preparer isn’t asking serious questions about these items, you need a new preparer.
Short on personnel and funding, the IRS audits less than 1% of all individual tax returns annually. We expect the audit rate to fall even lower as resources continue to shrink and even more employees are reassigned to identity theft cases. So, the odds are pretty low that your return will be picked for review. And, of course, the only reason filers should worry about an audit is if they are fiddling on their taxes.
With these facts in hand, your chances of being audited or otherwise hearing from the IRS increase with key factors, including your income level, the types of deductions or losses you claim, how you make your money and whether you own foreign assets. Math errors may draw IRS inquiry, but they will rarely lead to a full-blown exam. Although there’s no sure way to avoid an IRS audit, these 7 red flags could increase your chances of unwanted attention from the IRS.
Making Too Much Money
Although the overall individual tax audit rate is only about one in 100, the odds increase dramatically as your income goes up. Recent IRS statistics show that people with incomes of $200,000 or higher had an audit rate of 3.26% or one out of every 30 returns. Report $1 million or more of income? There’s a one-in-nine chance your return will be audited.
We’re not saying you should try to make less money—everyone wants to be a millionaire. Just understand that the more income is shown on your return, the more likely it is that you’ll be hearing from the IRS.
Failing to Report All Taxable Income
The IRS gets copies of all 1099s and W-2s you receive, so make sure you report this income. IRS computers are pretty good at matching the numbers on the forms with the income shown on your return. A mismatch sends up a red flag and causes the IRS computers to spit out a bill. If you receive a 1099 showing income that isn’t yours or listing incorrect income, get the issuer to file a correct form with the IRS.
Taking Large Charitable Deductions
We all know that charitable contributions are a great write-off and help you feel all warm and fuzzy inside. However, if you’re claiming charitable donations as a deduction that is disproportionately large compared to your income, it could trigger a tax audit.
That’s because the IRS knows what the average charitable donation is for folks at your income level. Also, if you don’t get an appraisal for donations of valuable property, or if you fail to file Form 8283 for noncash donations over $500, you become an even bigger audit target. And if you’ve donated a conservation or façade easement to a charity, the chances are good that you’ll hear from the IRS. Be sure to properly document everything.
Also, check the organization is legit and it’s registered as tax-exempt.
Claiming Rental Losses
The IRS is actively scrutinizing rental real estate losses, especially those written off by taxpayers claiming to be real estate pros and whose W-2 forms or other businesses show lots of income. Agents are checking to see whether these filers worked the necessary hours, especially in cases of landlords whose day jobs are not in the real estate business. The IRS started its real estate professional tax audit project several years ago, and this successful program continues to bear fruit.
The rules require you to spend more than 50% of their working hours and 750 or more hours each year materially participating in real estate as developers, brokers, landlords or the like to write off losses without limitation. Also, if you actively participate in the renting of your own property, you can deduct up to $25,000 of loss against your other income. But this $25,000 allowance phases out as adjusted gross income exceeds $100,000 and disappears entirely once your AGI reaches $150,000.
Deducting Business Meals, Travel and Entertainment
Schedule C is a treasure trove of tax deductions for self-employed. But it’s also a gold mine for IRS agents, who know from experience that self-employed sometimes claim excessive deductions. History shows that most underreporting of income and overstating of deductions are done by those who are self-employed. And the IRS business audit looks at both higher-grossing sole proprietorships and smaller ones.
Big deductions for meals, travel, and entertainment are always ripe for audit. A large write-off here will set off alarm bells, especially if the amount seems too high for the business. Agents are on the lookout for personal meals or claims that don’t satisfy the strict substantiation rules. To qualify for meal or entertainment deductions, you must keep detailed records that document for each expense the amount, the place, the people attending, the business purpose and the nature of the discussion or meeting. Also, you must keep receipts for expenditures over $75 or for any expense for lodging while traveling away from home. Without proper documentation, your deduction is toast.
Also, you can see how to deduct these business expenses with confidence and reduce the chances of a tax audit.
Claiming 100% Business Use of a Vehicle
When you depreciate a car, you have to list on Form 4562 what percentage of its use during the year was for business. Claiming 100% business use of an automobile is red meat for IRS agents. IRS agents are trained to focus on this issue and will scrutinize your records. Make sure you keep detailed mileage logs and precise calendar entries for the purpose of every road trip. Sloppy recordkeeping makes it easy for the revenue agent to disallow your deduction.
This is usually a case that we see with ride-hailing drivers and sometimes increases the risk of a tax audit.
As a reminder, if you use the IRS’ standard mileage rate, you can’t also claim actual expenses for maintenance, insurance, and other out-of-pocket costs. The IRS has seen such shenanigans and is on the lookout for more.
Claiming the Home Office Deduction
Like Willie Sutton robbing banks (because that’s where the money is), the IRS is drawn to returns that claim home office write-offs because it has found great success knocking down the deduction and driving up the amount of tax collected for the government.
If you qualify, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance and other costs that are properly allocated to the home office. That’s a great deal. And beginning with 2013 returns, you have a simplified option for claiming this deduction. The write-off can be based on a standard rate of $5 per square foot of space used for business, with a maximum deduction of $1,500.
To take advantage of this tax benefit, you must use the space exclusively and regularly as your principal place of business. “Exclusive use” means that a specific area of the home is used only for trade or business, not also for the family to watch TV at night, or as a guest bedroom or children’s playroom. Don’t be afraid to take the home office deduction if you’re entitled to it. The risk of an audit should not keep you from taking legitimate deductions. If you have it and can prove it, then use it.
Being Realistic and prevent a tax audit
According to the IRS statistics, individuals that are in the higher tax brackets and filers that report no income at all get the most attention for audit.
Basically, in our practice, we met folks that push the boundaries of what is reasonable. And we advise our clients to be conservative with their returns, so extra scrutiny won’t be triggered.
As long as, your income is well documented and has proof of the source for the salary -your good.
The chance of a tax audit would be slimmer. You don’t need that anxiety hanging on your head every year.
If you have any questions or concerns before filing, call us or schedule to come in so we can review your return.
