Kids have the bogeyman, adults have tax audits.
If you’re worried about triggering tax audit red flags, this article is for you.
In a statement earlier this year, the IRS noted that, “Based on ongoing examination activity, audit rates for income categories between $500,000 and $1 million doubled to 0.6%. Audit rates for the $1 million to $5 million category more than doubled to 1.3% and taxpayers earning more than $10 million jumped four times – reaching 8%.”
Ironically, this announcement arrived on the heels of comments on the overall decrease in IRS audits by the U.S. Government Accountability Office. But, even if the IRS is conducting fewer audits these days, it’s always a good idea to employ best practices so you avoid triggering red flags with the IRS.
What is an IRS tax audit?
The IRS defines an audit as a review of an entity’s or individual’s tax return to verify the information reported in the return and ensure the information is reported in compliance with tax laws.
How are IRS audits triggered?
Being selected for an IRS audit doesn’t mean that there is a problem with your return specifically. In reality, there are a few different reasons why an IRS audit of your tax return may be triggered:
- When your return is part of a randomized selection to aid statistical modeling
- If your return is connected to an entity or individual whose return was selected for an audit
- There is a discrepancy on your tax return that requires additional verification
Randomized selection to build statistical models
The IRS uses a computer system to perform automated scans of tax returns and detect anomalies. Like all computers, these machines need data samples to build models and trends of what is considered “normal” for a tax return. As the IRS notes, “We develop these ‘norms’ from audits of a statistically valid random sample of returns, as part of the National Research Program.”
Your return is linked to a return that is being audited
Like bad apples spoil good ones, a return that’s being audited can also trigger red flags for any connected tax returns as well. This means that, even if your return is flawless and error-free, you can be selected for an audit if you engaged in transactions with an entity or individual whose returns are being audited.
There is a mistake on your return
While there are certainly unscrupulous criminals who engage in fraudulent and illegal tax activities, even honest taxpayers make mistakes. These mistakes can trigger an audit to request an amendment or additional verification.
What is the tax audit process?
Once a red flag is raised and a return is selected for an audit, it undergoes manual review by an expert IRS auditor who reviews the discrepancy and makes note of which items are lacking. Once they’re done, the IRS auditor sends the tax return to an IRS examination group.
Types of tax audits
When a tax return reaches the examination group, the IRS conducts one of the following types of audits (as described in IRS Publication 4386):
- Audits: Also called a field audit, the IRS sets an appointment for an IRS agent to visit your office.
- Examination: Known as a correspondence audit, the IRS asks you to deliver additional documentation to an IRS office
- Compliance check: Technically, this is not an audit but an assessment to determine whether items have been properly reported
Note: The IRS will always initiate a tax return audit through mail. They will never call you to initiate an audit by telephone. Telephone-based “IRS audits” are not legitimate, but rather a tactic used by scammers to glean sensitive information or extort money from you. These fake IRS calls are listed in the “Dirty Dozen” list of IRS scams.
What happens during a tax audit?
The IRS provides many audit guides for specific circumstances and industries, known as Audit Techniques Guides (ATGs), to guide IRS professionals and educate tax professionals and taxpayers about the audit process. The IRS provides ATGs for the following industries:
- Aerospace industry
- Air transportation
- Art galleries
- New vehicle dealership
- Attorneys and lawyers
- Retail industry audits
- Business consultants
- Guide for assessing capitalizations and dispositions of tangible property
- Cash-intensive businesses like bail bonds, beauty shops, taxi cabs, car washes, coin-operated amusements, laundromats, scrap metal shops, and some convenience stores
What documents does the IRS request during a tax audit?
The IRS will always provide a written request listing the specific documents needed for your particular situation. However, the IRS does provide a general list of records that it may request from you during an audit, including:
- Canceled checks
- Legal papers like divorce settlements or custody agreements
- Loan agreements
- Logs or diaries
- Medical and dental records
- Theft or loss of documents
- Employment documents
- Schedule K-1
- Electronic documentation generated by tax software or accounting software
13 Red Flags That May Trigger IRS Audits
You will most likely be fine if you give your best effort to provide accurate information while completing your tax return. But, if you’re concerned about triggering an IRS audit, I’ve put together a list of the top IRS audit triggers for you.
#1: Not reporting all taxable income
The IRS gathers data about your income from third parties and companies that are automatically compared to your filed tax return. If there is a discrepancy, an audit is triggered and the IRS takes a closer look.
#2: Earning a high income
According to a 2020 statement by Deputy Commissioner Sunita Lough, “The likelihood of an audit significantly increases as income grows.” As income level increases, the complexity of your tax return will likely increase and increase the chances of triggering an IRS audit. Take a look at the following comparison of IRS audit rates.
Simply put, making more money increases your chances of being audited by the IRS. This doesn’t mean you try to become wealthy. Instead, be as accurate as possible when filing taxes and, if you want to do things the smart way, hire a CPA to help you plan a great tax strategy.
#3: Too many tax deductions or tax credits
As mentioned earlier, the IRS compares your return to a computerized aggregation of other returns within your income bracket. If you take an excessive amount of tax deductions or tax credits – beyond what is normally seen in returns within your tax bracket – the IRS will take a closer look at your tax return.
“Taxpayers who exercise their best efforts to file their tax returns and pay their taxes, or enter into agreements to pay their taxes, deserve to know that the IRS is pursuing others who have failed to satisfy their filing and payment obligations,” said Eric Hylton, the commissioner of the IRS’ Small Business/Self-Employed Division.
In 2020, the IRS invested considerable resources into contacting and educating high-income non-filers about their tax obligations. If you are required to file a tax return but have not done so, you can expect a notice from the IRS informing you of your tax obligations and outlining payment options available to you. Non-compliance can result in levies, liens, and possible conviction.
#5: Cash businesses
If you operate a hair salon, barber shop, or other cash-based business, this is for you. Excessive amounts of cash transactions get the IRS’ attention because they are harder to track than credit cards. It’s important to thoroughly document all cash transactions that will present an accurate, complete picture to the IRS. If you have cash transactions over $10,000, remember to file IRS Form 8300 to notify the IRS about them.
#6: Claiming excessive business expenses
If the IRS notices an excessive amount claimed on your tax return compared to others in your tax bracket, you may trigger an IRS audit. This is not to say that you should avoid claiming legitimate deductions. If you can claim a deduction, by all means, do it. But, be very careful to substantiate your claim with receipts and other supporting evidence.
Here are some tips to help you avoid trouble when claiming business expenses:
- Keep mileage logs for business travel or opt for the standard mileage deduction.
- Separate your personal and business expenses so you can track which are legitimate tax deductions and which are not.
- Make sure all vehicle-related deductions have a specific purpose assigned to them, especially since take-home vehicles can be used for non-business purposes.
#7: Home office deduction
Working from home can be a great way to balance your personal life and your work life, which is why several of our team members have committed to fully working from home. Ideally, you should set up a dedicated workspace, whether it’s a room or office, so you can stay productive and focused during your work hours.
Okay, this might be a bit extreme. But every parent has had the idea at least twice while working from home.
If you’re trying to take advantage of the home office deduction, there are a couple of ways to go about it, including the simplified home office deduction and actual expenses home office deduction.
But, as with most things related to taxes, there are many mistakes that can be made if you’re not diligently checking the details of your deductions. Here are some of most common ones:
- Not using the space exclusively and regularly for business: This means you can only use the space for business purposes – always, no exceptions.
- Blurring work and side hustle locations: If you work from home and also have a side hustle, you cannot use the same space for both jobs and claim the home office deduction. This would violate the exclusivity test described above.
- Take pictures of your home: This will prove helpful during a tax audit, especially if you move to another house. Having photo evidence of your home and home office will go a long way in justifying your deduction.
#8: Engaging in virtual currency transactions
One of the biggest joint initiatives of the IRS and SEC recently is cracking down on cryptocurrency transactions as more investors flock to virtual currencies like Bitcoin, Ethereum, Binance, XRP, and others.
Earlier this year, this battle once again made headlines as the IRS asked federal judges to allow summonses on SFOX and M.Y. Safra Bank, two major players within the cryptocurrency. As cryptocurrency transactions have increased over the past few years, the IRS is taking action to enforce tax compliance with cryptocurrency activities. On the new Form 1040, the IRS now asks whether you’ve received, sold, exchanged, or disposed of virtual currencies within the tax year.
If you buy or sell virtual currencies, you’ll either receive Form 1099-K or 1099-B. You are required to file this form with the IRS so the agency is aware of your activities and cryptocurrency assets.
#9: Failing to report a foreign bank account
Under the Foreign Account Tax Compliance Act:
- International banks must disclose American asset holders to the IRS
- Taxpayers must report foreign assets worth at least $50,000 to the IRS using Form 8938
Previously, you only had to disclose that you had an overseas bank account. But, now that the IRS has adopted more stringent measures to improve transparency, you must disclose the institution and the account’s highest balance for the previous year.
Foreign accounts can be tricky. With increased transparency comes a higher likelihood that you’ll be audited since the perception of offshore accounts is that taxpayers use them to hide funds from the IRS. On the other hand, failure to disclose foreign accounts results in severe penalties and legal trouble.
If you have an overseas account, be sure to keep records of the following:
- Name on the account
- The account number
- The contact information for the institution
- Account type
- The highest balance or maximum value for the year
#10: Taking the American Opportunity Tax Credit for more than 4 years
The American Opportunity Tax Credit is a great tax opportunity if you are a college student or have college students in your home. Where people go wrong is when they try to claim the AOTC for more than four years or submit the required Form 8863 without including the school’s ID. The credit is refundable, but there are income limits, and requires at least half-time enrollment.
#11: Using an unethical tax professional
If you hire a tax professional whose returns aren’t filed on time or who engages in tax fraud themselves, chances are that you’ll end up with a tax return that gets flagged by the IRS. Here are some tips to help you pick a scrupulous tax professional:
- Consider their qualifications: Are they certified to prepare taxes for you? A credible tax professional will typically be connected to a professional organization of tax professionals.
- Check out their website: Does it look professional and modern? If they’re serious about their business, you’ll be able to tell from their website.
- Look at reviews and testimonials: What do previous or current clients say about the tax professional in their review? This will give you an idea of what to expect when working with them.
Related Reading: Hiring a tax professional? How to pick the best one.
#12: Claiming losses on a hobby
A common tax mistake among Schedule C filers is reporting losses on a hobby to offset income from elsewhere. The IRS only considers you to have a business if you’re operating in a business-like manner.
#13: Claiming excessive charitable contributions
There’s nothing wrong with donating to charities to support causes you believe in. But, problems can arise if you claim an excessive amount of charitable deductions. If you’ve donated cash or non-cash items to a nonprofit and are itemizing your deductions, be sure to hold on to any documentation from the charity about your documentation.
Don’t wait until you’re audited to get proof of your donation from the charity. Save yourself a headache and hang on to documentation at the time of your donation.
Being proactive helps you avoid triggering tax audits
Keeping thorough records to substantiate expenses and tax information is one of the best ways to proactively avoid a tax audit. If you have questions about your taxes, contact a tax professional rather than risking a DIY return and possible IRS attention.