27 IRS Red Flags that Might Trigger a Tax Audit
Are there IRS Red Flags that taxpayers should Avoid?
Every year, the IRS audits a little more than 1% of all individual tax returns. The IRS doesn’t have the necessary personnel to examine too many more than they currently do. The tax returns the do audit are specifically-selected by selecting those tax returns that will most likely result in uncovering unreported income, overstated deductions, false claims, or by targeting tax payers that haven’t filed tax returns every year. The odds are in your favor that you will fall into the 99% of non-audited tax returns, but there are some IRS Red Flags that, IF YOU AVOID, will help keep you from the audit pool group.
The chances of you being audited by the IRS depend upon many factors such as: your annual income; if you fail to report income that IRS has filings to the contrary; the types, sizes and ratios of deductions or losses you claim; whether you work for a company or self-employed; what field you work; if you own a business and the type of business you own; and if you own foreign assets or bank “offshore.” Sloppy tax returns, hand-written tax returns, errors in math, discrepancies between state and federal tax returns, and wide fluctuations in reported earnings from one year to the next year may can trigger an IRS inquiry to clarify some details but may not expand into an actual audit. Though there is no absolute way to avoid an IRS audit, you can reduce your chances of an audit by avoiding common IRS red flags.
27 Common IRS Red Flags that can trigger an Tax Audit:
- You earn too much money – Who knew – right? There’s not much you can do about this RED FLAG. The reality is that government tax agencies are tasked with collecting as much money as possible, so they go “where the money is!” While the overall individual audit rate is 1.11%, the odds increase dramatically for high-income tax filers. In 2011 taxpayers with incomes of $200,000 or more had an audit rate of 3.93%. That is a 400% greater likelihood of being audited! If you are in the $200,000+ group, 1 of 25 returns are audited. Taxpayers who reported $1 million or more in earnings are subjected to a 1 in 8 chance for audit! The audit rate drops dramatically for taxpayers reporting less than $200,000 where only 1.02% of tax returns were audited during 2011.
- You earn too little money — If your income is suspiciously low for your profession or job description when compared to the average incomes on the IRS computer tables, will make your tax return more likely for audit.
- Fluctuations in income — Unexplained fluctuations in income from year to year suggests that income may have been under reported in one of the low income reporting years. Most taxpayers do not have dramatically up-and-down swings in income and the IRS will want to know why.
- Failing to report all taxable income – The IRS gets copies of all 1098’s, 1099’s, and W-2’s. Therefore, if you miss attaching your copy to your tax return and some of your income reporting does not match the records the IRS has, you are more likely to be audited.
- You own a business – Unfortunately, business owners are considered “low hanging fruit” for IRS revenue agents who know that they can almost always find overlooked or underpaid tax liabilities anytime they audit a business.
- You are a sole proprietor business – All Schedule C filers are even more of a target than incorporated business owners. TO remove this RED FLAG< you might want to consider incorporating where a Schedule C is not used.
- Deducting business meals, travel and entertainment – Schedule C is essentially a long list of tax deductions for those who are self-employed. It is also a punch-list for IRS Investigator’s who will try to shoot down some of those same deductions as an over-reach by the tax payer. IRS revenue agents are quite skilled at challenging travel expenses, personal meals, and other less-than-solidly-documented claims that fail to live up to the deduction rules. For example, to qualify entertainment and dining deductions, you must maintain exacting records that document for each expense the amount, the establishment, the names and business relationships of people attending, the business purpose and the nature of the discussion at the meeting. These deductions might be more closely scrutinized if they closely coincide to holidays, family members’ birthdays, wedding anniversaries etc. Agents have a list of all your family member’s birth dates and likely your wedding date. IRS investigators are rewarded for being good at uncovering “iffy” expenses and deductions and if they challenge deductions one year, often past years’ tax returns are then added to the audit examination.
- You own a mostly-cash business or work for a “mostly cash business” – Worse that being a sole proprietor filing a Schedule C, being involved in a mostly cash business is a red flag for a tax audit. Businesses that are mostly cash are: taxi services, limo services, car washes, bars, nightclubs, restaurants, dry cleaners, laundromats, vending routes, waiters and waitresses, etc.
- Business with family members on the payroll — A common method to dodge taxes is to have one or more family members on the payroll to facilitate taking more money out of a business at an overall lesser-taxable rate. While there is nothing illegal in family members on the payroll, IRS revenue investigators look to see that such family members are actually working and any money they earned is not simply being handed back to the business owner as a scam of the tax system.
- Suspicious business deductions — IRS investigators are no fools. They know that business owners preparing their tax returns are looking for big ticket receipts that might be deductions that will offset taxable income. While it might be tempting to book your high school students’ computer purchased on December 23rd as a business deduction, would that fly if scrutinized? What about the the $600 receipt for the iPad you purchased the day prior to your wife’s birthday? How about that ski trip to Colorado for your wedding anniversary – are you really going to expense the gas, hotel, and meals as a business trip? Would that fly if scrutinized? IRS auditors know when Christmas is; they also know the birth dates of your family members and possibly even your wedding date. They are trained to look for significant purchases and expenses in the days immediately prior to birth dates, anniversaries, Christmas, etc. which are claimed as business deductions when, if fact, they are not.
- Higher-than-average deductions – If the deductions on your tax return are disproportionately large compared with your income, the IRS computers may flag your tax return for a human review and possible a tax audit.
- Home office deduction – Claiming the Home Office Deduction has been a Red Flag for decades. The IRS has been super-vigilant and skeptical of tax returns claiming the home office deduction and the associated write-offs because they have been so successful in discrediting such claims for decades. To legitimately use the home office deduction, you must use the “claimed square footage” exclusively and regularly as your principal place of business. Shared rooms and spaces are NOT legitimate. IRS Revenue agents always want to conduct these audits at your home so they can see first hand if your claim seems valid. SOME SOFTENING: The home office red flag of the 1990’s, is no longer as large of a red flag because there has been a dramatic increase in telecommuters and freelancers who work from home and legitimately claim this deduction. The Internet has had significant influence on this trend, coupled with the on-going recession beginning back in December 2007. Workers who were laid off, have become self-employed 1099-workers attempting to re-establish their careers from home. It is still a red flag, so if you are targeted to be audited, the IRS will likely want to check out your home office and literally measure your square footage to make sure you are not abusing the deduction.
- Claiming 100% business use of a vehicle – When you depreciate a car, you have to list on IRS Form 4562 of what percentage of its use during the year that you claim (testify on a Federal form by your signature) was for business. Claiming 100% business use of an automobile is often a foolish blunder – even if true (sometimes it is wiser to pay a few extra bucks in taxes in exchange for being lower on the computer audit scoring). The IRS knows that it is extremely rare for an individual to actually use a vehicle 100% of the time for business, especially if no other vehicle is available for personal use.
- Wrong or indecipherable social security number – Not double-checking ones’ tax return before filing is plain old sloppiness which accounts for many needless tax audits.
- Discrepancies between Federal tax returns and state returns — This is simply another example of sloppiness and how it can come back at you. Be sure that your information matches on both your state and Federal returns. Government tax agencies compare notes.
- Common math errors – If you mess up on your math, the IRS is going to wonder what else you were careless with. Better to double and triple-check your numbers before you mail or press the “submit” button.
- You have been audited before – Once you have been audited, you may remain on the “suspect list” for a few years. Suggestion? File conservative tax returns with as few red flags as possible.
- You picked a sub-par tax preparer – Some devious tax preparers will advertise or promise that they can deliver huge tax refunds when compared to other tax preparers. The huge refund they calculate may have earned them a tax preparation fee, but now you will pay the bigger price of a follow-up audit, and possibly a underpaid tax assessment, penalties and fees. When selecting a tax preparer, better to look for a full-time professional and insist they go conservative on any deductions or claims that might be sketchy or hard to document. If a particular tax preparer is “known” by the IRS as filing over-reaching or sloppy returns, you may be targeted for audit JUST BECAUSE of the tax preparer you chose.
- Large charitable deductions – if your claimed charitable deductions are disproportionately large when compared with your income, you are asking that your return be kicked out for review and possible follow-up tax-audit. The IRS has tables of “normal ratios” of what average charitable donations are for people in your similar demographic and similar income level. If your charitable deductions are greater than 10% of your income, make certain that your records are in order and that an audit would not cause you other troubles. While it is lawful to give as much as you wish, you must weigh the red flag and likelihood of being audited.
- Guessing when a stock or investment was purchased or sold – the IRS has records of these dates, so if would be wise that you do your homework and get your dates nailed down. When your dates do not line-up, a red flag goes up that you might be hiding something.
- Using Round numbers on tax return — Let’s face it, it is extremely unlikely that your investment returns were exactly $1,500, or that your mortgage interest deduction was $10,000. Recording multiple round numbers on a return are a red flag of a sloppy taxpayer and a red flag is raised that something sketchy is going on with the tax payer.
- Irregular tax returns filers – A Taxpayer already red-flagged as a “non filer” adds to the chances for an audit
- Claiming a loss for a “hobby activity” – if you have some income from a hobby that is also considered “fun” such as auto racing, boat racing or horse racing, and you then file a Schedule C with large losses against a so-called “hobby business,” you’re asking for increased tax return scrutiny.
- Large currency transactions – The IRS gets many reports of cash transactions in excess of $10,000 involving casino visits, banks deposits and withdrawals, and via car dealers and similar cash businesses. Many banks report large cash withdrawals but never inform their customers that they do so.
- You are in a targeted industry – Each year the IRS selects a group of targeted professions (some say “victims”). One year the IRS audits chiropractors, and the following year mostly-cash car washes. It may be by mere bad luck that you fall into a focused demographic targeted for audit.
- Failing to report foreign accounts – The IRS is hyper-focused on any individuals who have offshore bank or securities accounts —especially those in tax haven countries. If that is you, contact a tax attorney at once.
- Handwriting your return – Seems strange – right? Not really. Handwritten tax returns now stand out simply because it is now so unusual. Better to fill out a PDF form online and print a hardcopy and then mail it. That said, whenever possible, electronically file your return.
Suggestions to taxpayers wanting to avoid Red Flags
If you have legitimate significant charitable contributions, home office expenses, or Schedule C losses you still might want to take a step-back and rethink the “bigger picture” before piling up one or more so-called “IRS red flags” deductions, expenses, write-offs on your tax return if:
- There are other items on your current year’s tax return (or on your last 2 years’ tax returns) that you really wouldn’t want the IRS to closely scrutinize because of an audit that is triggered by the return you are currently preparing.
- If the monetary expense and mental stress of an audit scare you, are the various deductions, expenses, write-offs you are now “considering claiming” worth it? Or would you trade a few “red-flag” income offsets to remain in the 99% group who won’t have a greater chance of an IRS audit?
It is a good idea to review your proposed tax return options with the help of a qualified CPA, IRS enrolled agent, or —if you value attorney-client privilege— a tax lawyer.
If you decide to take advantage of the tax savings possible by using one or more of the more-common red flag deductions, there are some things you can do to reduce the chances of “standing out” from the crowd:
- File your return on time;
- Use a respected CPA, IRS Enrolled agent/preparer, or tax lawyer to assist in preparing your tax return
- Have the CPA, IRS Enrolled agent/preparer, or tax lawyer sign your tax return as tax preparer; or
- If you insist on self-preparing, use a well-know software program to prepare your tax return;
- File your tax return electronically – not by mail; and
- Attach explanatory forms and/or statements to your tax return where necessary.
Get some help —Make that call!
Are you facing an audit, or afraid you might becoming an audit candidate? – Tax Resolution Lawyer, Paul Staley, provides a no-obligation, confidential consultation and has appointments available for evenings and weekends. We accept all major credit cards and can make other payment arrangements so that we can help you get your tax problems straightened out without adding additional layers of financial burden on you and your family. Call Paul at (619) 235-9645.