A tax audit has to be one of the scariest terms in the in the English language. We’ve all seen the stereotype image of having to go and be questioned by tax authorities, defending our tax returns and it all seems like a scenario out of the Spanish Inquisition.
Have you ever wondered what kinds of things stand out like a sore thumb to prying IRS agents?
A tax audit does not have to be a scary or stressful event after all if you were honest in your return then answering a few questions really shouldn’t matter. That’s why it’s always good to have your returns handled by a professional like a CPA who can help you get the best return possible while making sure everything is being done right and if you do get audited the CPA will go and represent you to the IRS.
In reality the IRS only audits about 1% of all the tax returns for any given year so the chances of you getting picked are pretty slim. Nonetheless these 12 red flags have proven over time to give you a higher chance of getting an audit than not.
1. Making Lots Of Money
We all want to be rich and make millions every year but the reality is the more money you make the more the IRS will be watching to make sure Uncle Sam gets his cut. Nationally the audit rate is 1.11% but those making more than $200,000 per year have an average audit rate of almost 4%. If you’re a big earner and you make over $1 million per year then your audit rate skyrockets to 12.5%.
2. Not Reporting All Taxable Income
Remember your employer and financial institutions all send copies of your W2’s and 1099’s to the IRS. When your return is filed the IRS computers search to match up your reported income and what is on file if things don’t match then your return is flagged for follow up by an IRS agent.
3. Large Charitable Deductions
I’m a huge fan of donating to charities and helping those in need and I think it’s great there is a tax write off for donations. However the IRS knows what the average charitable contributions are for your region and income bracket and when your claims are significantly higher the computers will flag your return for follow up. As long as you have the correct corresponding paper work to validate the deduction than give give give but just know it will raise some flags.
4. Home Office Deduction
This is a deduction the IRS is drawn to like a moth to fire. They have had lots of success in disqualifying the deduction for many people due to the very strict interpretation of “Exclusive Use.” If you qualify for the deduction you are allowed to write off a portion of the expenses associated with having an office at home such as mortgage/rent, property taxes, utilities, insurance, etc… however the space must be for exclusive and regular use for business. Making it very difficult to claim a spare bedroom or living room as an office even if you spend lots of time working in there.
5. Rental Losses
If you have a rental and you actively participate as a landlord then you are able to write off certain losses up to a point or if you spend the majority of your time as a professional in the real estate business then you can write off all losses with no caps. This of course always throws up some flags and the IRS will come searching to see if you really qualify for this deduction. Did you really spend 50% of your working time in real estate? Were you actually actively involved in the property management? These are the kinds of things they will require you to verify.
6. Business Meals, Travel & Entertainment
For the self-employed Schedule C is a great source of tax deductions helping many small businesses; however, it is also one of the first places IRS agents look because it provides just as many opportunities for them to disqualify deductions. They are looking for instances when personal meals or trips were written off as business therefore big deductions for meals and trips are flagged for audit many times. Always make sure you have lots of verifying details and records for any business meals, trips or entertainment that you will write off. When it comes to the IRS the assumption is the deduction does not qualify until you can prove it – guilty until proven innocent.
7. 100% Business Use Of A Vehicle
This is another area where IRS agents are just salivating at the opportunity to invalidate your deduction. If you use your vehicle for business on Form 4562 you have to notate what percentage of use was for business, claiming 100% will send up many red flags. Once again keeping ultra-detailed records is key here. Sloppy records and the IRS will instantly disqualify the deduction. As an FYI if you use the IRS’ standard mileage rate then you can’t ALSO claim the actual expenses for maintenance, insurance, etc… it’s either or not both. This is one thing the IRS is always keeping a close eye on.
8. Losses On Hobbies
If you are a wage earning employee and you file a Schedule C with a large loss and your loss seems like it’s a fun hobby – think car racing or horse breeding then you just won yourself an audit. It’s a funny thing the way the IRS works because if you make money from a hobby then you have to report it, you can deduct expenses of a hobby up to the amount you made but they forbid you from claiming losses on hobbies. So the IRS is always going over a Schedule C filing with a fine tooth comb and looking for things to disqualify.
9. Cash Business
If you run a cash intensive business the IRS will be keeping a close eye on your returns. Examples would be a taxi cab driver, restaurant, car wash, etc… The IRS has a special training they give their field agents all about finding unreported income from cash heavy businesses, they know it’s a prime place for finding more tax revenue.
10. Foreign Bank Accounts
This is one area that has gotten lots of news in recent years about US citizens having unreported foreign bank accounts. It is a top priority for the IRS to collect tax money on these foreign assets and they are using all sorts of new techniques to track people down with foreign bank accounts. The penalties are very high and just isn’t worth the risk. Always report all your holding on your tax returns.
11. Currency Transactions
All cash transactions in excess of $10,000 are reported to the Treasury Department and in recent years this information has been shared with the IRS. A recent report from the Treasury Department concluded that Currency Transactions are a powerful lead in finding unreported income and IRS will begin using these reports more and more in their auditing protocols. So if your business involves lots of Currency Transactions then be prepared for much more IRS scrutiny.
12. Above Average Deductions
Like in the case with charitable deductions the IRS computers have the average ranges for deductions for others in your same situation and whenever you fall out of that band then it will flag your return. It’s important to remember though even if your deductions are high as long as you’re being honest and truthful and you have the supporting documentation then take the deductions you’re entitled. There is never ever any reason to overpay your taxes and give the IRS more than necessary.