Top reasons your tax return could get red-flagged by the IRS for potential audit
As the 2021 tax filing season is upon us, CNBC recently published an article on some of the common reasons that a self-employed business owner or tax filer could have their tax return red-flagged by the IRS. Now the article points out that “while the chances of an audit are slim, there are several reasons why your return may get flagged, triggering an IRS notice.” according to some tax experts. And according to another article from Investopedia, fewer than 1% of Americans were audited (The IRS closed 452,515 individual audits during its fiscal 2020, about 0.29% of the roughly 157 million individual income tax returns filed) by the Internal Revenue Service (IRS) last year. Plus, most audits are handled solely by mail, meaning taxpayers selected for an audit typically never actually met with an IRS agent in person.
And although some people play the audit lottery, meaning they’ll do whatever they want, and know that the chances of getting caught are slim, that is not the smartest strategy to go with. As I am writing this article, The Wall Street Journal published an opinion piece in by Jay Starkman titled “Good News, Tax Evaders! The IRS Can’t Keep Up” in which he argues that the agency needs more auditors, greater efficiency and computer systems that weren’t made in the ’60s. Further explaining “The IRS is on the verge of collapse. Some members of Congress are fixated on the “tax gap”—uncollected tax revenue the Biden administration estimates is $600 billion. The IRS could collect taxes better if it were efficient, fully staffed and had up-to-date technology, responsive customer service and reasonable audit coverage.”
And of that small percentage, some of the audits are totally random. But many are triggered by actions taxpayers themselves have taken. This article will cover is a list of red flags that can cause your tax return to be targeted by the IRS for review. It is useful to know what these typical triggers are, which can save you a lot of trouble and anxiety. The personal finance advice publication Kiplinger put together a pretty comprehensive article about 23 IRS audit red flags.
- Overvaluing home office expenses and donated goods are red flags to auditors.
- Simple math mistakes and failing to sign your tax return can also trigger audits.
- The odds of an audit increase with six-figure incomes, but under-reporting your earnings is ill-advised.
- Small business owners and limited partnership participants are at greater risk of being audited.
- Trying to claim too many credits or deductions compared with your income
- Failing to report all taxable income
David Silversmith, a CPA and senior manager of PKF O’Connor Davies, told CNBC “that the IRS uses software with a numeric score for each return, with higher scores more likely to spark an audit.” The system estimates the appropriate range for each deduction or credit by income level, and if write-offs are outside that range, scores may increase. Mr. Silversmith gave an example, saying a tax filer who had reported $90,000 in earnings with $60,000 in charitable deductions could alarm the system.
1 Omitting or under-reporting taxable income
(image credit: fox Business news)
Tempting as it might be to exclude income from your tax return, it is vital that you report all monies that you received throughout the year from work and/or from the sale of an asset (such as a home) to the IRS. If you fail to report income and get caught, you will be forced to pay back taxes plus penalties and interest.
The IRS gets copies of all the 1099s and W-2s you receive, so be sure you report all required income on your return. IRS computers are pretty good at cross-checking 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 that the IRS will mail to you (these letters don’t count as audits for purposes of the IRS’s 0.4% audit rate). 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.
Report all income sources on your 1040 return, whether or not you receive a form such as a 1099 form. For example, if you get paid for walking dogs, tutoring, driving for Uber or Lyft, giving piano lessons, or selling crafts through Etsy, the money you receive is taxable.
2 Being in Higher Income Thresholds
There is nothing the individual taxpayer can do about this one, but if you earn more than $100,000 each year, your odds of being audited increase exponentially. In fact, some accountants put the odds of being audited at one in 72, compared to the one in 154 odds for people with lower incomes. Tempting as it may be, don’t try any questionable moves just to get your income out of five figures, though.
The IRS’s Large Business and International Division (LB& I) is even getting back into action. This specialized group within the IRS tackles examinations of the super-rich. Revenue agents take a kitchen-sink approach in auditing these individuals by reviewing not only their 1040 returns, but also the returns of entities they control, both foreign and domestic. Don’t be afraid of making more money, but you just need to understand that the more income that is shown on your return, the more likely it is that the IRS will be knocking on your door.
3 Taking Higher-than-Average Deductions, Losses or Credits
If the deductions, losses or credits on your return are disproportionately large compared with your income, the IRS may want to take a second look at your return. Taking a big loss from the sale of rental property or other investments can also spike the IRS’s curiosity. Ditto for bad debt deductions or worthless stock. But if you have the proper documentation for your deduction, loss or credit, don’t be afraid to claim it. Don’t ever feel like you have to pay the IRS more tax than you actually owe.
4 Overestimating Charitable Donation Amounts
The IRS encourages individuals to donate things like clothes, food, and even used cars to charities. It does this by offering a deduction in return for a donation. However, if your charitable deductions are disproportionately large compared with your income, it raises a red flag. That’s because the IRS knows what the average charitable donation is for folks at your income level. The problem is that it is up to the taxpayer to determine the value of goods that are donated. So if you don’t get an appraisal for donations of valuable property, or if you fail to file IRS Form 8283 for noncash donations over $500, you become an even bigger audit target. And be sure to keep all your supporting documents, including receipts for cash and property contributions made during the year. So for larger ticket items, consider having an appraiser write a letter, naming in his or her considered opinion the worth of the item. In fact, for individual items valued at $5,000 or more, an appraisal is required.
5 Small Business Ownership
Small business owners are an easy target—particularly those with cash businesses. Bars, restaurants, car washes, and hair salons are exceptionally big targets, not only because they deal in so much cash, but also because there is so much temptation to under-report income and tips earned.
Schedule C is a treasure trove of tax deductions for self-employed people. But it’s also a gold mine for IRS agents, who know from experience that self-employed people sometimes claim excessive deductions and don’t report all their income. The IRS looks at both higher-grossing sole proprietorships and smaller ones. Sole proprietors reporting at least $100,000 of gross receipts on Schedule C and cash-intensive businesses (taxis, car washes, bars, hair salons, restaurants and the like) have a higher audit risk. Ditto for business owners who report substantial losses on Schedule C, especially if those losses can offset in whole or in part other income reported on the return, such as wages.
There are other actions that are fairly common with running a business that may draw unwanted IRS interest, too, including putting family members on the payroll and overestimating expenses.
6 Engaging in Virtual Currency Transactions
The IRS is on the hunt for taxpayers who sell, receive, trade or otherwise deal in bitcoin or other virtual currency and is using pretty much everything in its arsenal. As part of the IRS’s efforts to clamp down on unreported income from these transactions, revenue agents are mailing letters to people they believe have virtual currency accounts. The agency went to federal court to get the names of customers of Coinbase, a virtual currency exchange. And the IRS has set up teams of agents to work on cryptocurrency-related audits. Additionally, all individual filers must state on page 1 of their Form 1040 whether they received, sold, exchanged, or otherwise disposed of any financial interest in virtual currency.
The tax rules treat bitcoin and other cryptocurrencies as property for tax purposes. The IRS has a set of frequently asked questions that address selling, trading, and receiving cryptocurrency, calculating gain or loss, figuring tax basis when the currency is received by an employee or someone else for services, and much more
This is not the complete red flag trigger list, as CNBC pointed out there are many others to be aware of. Self-employed filers need to be careful when claiming write-offs for a home office or a vehicle because those must be exclusively for business purposes, which may be more difficult to prove. you need to be precise when reporting credits and deductions. Preeti Shah, a certified financial planner and CPA at Enlight Financial explains that “round numbers are a tipoff that you’re just making these numbers up.”
The IRS will continue to use audits as a tool to increase collections, but that doesn’t mean that you have to be among the lucky few to be chosen. The key to avoiding an audit is, to be accurate, honest, and modest. Be sure your sums tally with any reported income, earned or unearned—remember, a copy of your earnings is being furnished to the IRS, as the forms say. And be sure to document your deductions and donations as if someone were going to scrutinize them. Because someone just might. Now whether you feel that the IRS agency, is outdated and understaffed or not, there are plenty of tax strategies that a good tax advisor can use to help you save money from good old Uncle Sam. Feel free to reach out to Huckabee CPA with any questions or for a free consultation about your specific situation.