Will You Be The Target Of An IRS Audit?
Top Red Flags That Can Trigger An Audit
According to the IRS’s 2021 Data Book, IRS employees processed more than 261 million tax returns and other forms for the fiscal year (FY) 2021. Over 738,000 tax returns were selected for audit and closed resulting in almost $26.8 billion in recommended additional tax due.
Why are some tax returns audited by the Internal Revenue Service while others are not? The IRS uses an audit selection system to flag certain tax returns that are outside the “norm” for that type of return. This system is based largely on a statistical formula and using “norms” collected from the National Research Program. A tax return may also be selected for audit if it contains issues that another related taxpayer (business or partner) is or was audited for. It can feel like the IRS is some omnipresent entity that’s always watching, but with a little knowledge and planning you can avoid some of the most common audit triggers and red flags.
So, what are the red flags that the IRS looks at to determine if your tax return is outside the “norm” or not? The list of triggers to an audit are extensive, ranging from simple errors in personal information to claiming certain credits or deductions. It is important to be able to pinpoint exactly what caused the audit so the issue can be addressed before new ones arise. You never want to give the IRS free range to go through your life
Below is a list of actions and tax positions that could be the reason your tax return was selected for audit.
1. Failing to Report All Taxable Income
Taxable income is typically reported to you on a W2 or 1099, but did you know the IRS gets copies of those as well? The IRS cross-references the income on your tax return with the income employers and payers report. If there is a mismatch an automatic red flag is raised. This is why it is important that you include all your income on your tax return.
The most common income to go unreported is self-employment income, early withdrawals or distributions from a retirement account, gambling winnings, and canceled debt. Oftentimes taxpayers aren’t intentionally trying to cheat on their taxes. They just have a misunderstanding of what income is taxable or not.
If you fail to report all your taxable income, you could trigger a type of audit called an AUR (Automated Underreporting). The IRS will send you a type of letter in the mail called CP2000. This letter will list the income you reported to the IRS and compare it to all the income that was reported to the IRS by employers and payers. It will propose an additional tax amount due, including interest and penalties. To avoid this, make sure you report all of your taxable income when you file your tax return.
2. Too Much or Too Little Income
Audit rates have decreased significantly over the past decade. But there are still certain income brackets more likely to be audited than others.
Higher income brackets ($500,000+) see increased audit rates. This makes sense as the IRS potentially has more revenue to gain by auditing taxpayers who earn more.
What may come as a surprise to some, is that if you report little or no income at all, then you also have a higher chance of being audited. If your adjusted gross income is $25,000 or less an exam may focus on improperly claimed deductions and question if you have reported all your income. The IRS can compare the income you reported with the cost and standards of living in your area. If it is questionable how you can live where you do on the income you report, your return could be selected for audit.
3. Typos and Math Errors
You switched two digits in your social security number. You used your maiden name instead of your new legal last name. You left off a zero or added in a one somewhere it wasn’t supposed to go. All by mistake and easily explained. However, these simple errors can lead to an audit.
The IRS updates its systems frequently with the social security administration, checks your data with other sources, and uses its own algorithms and software to verify all calculations and information reported. If one little thing is off, the error is noticed automatically.
Be sure to always double your return for simple errors, even if you have had it professionally prepared.
4. Claiming Certain Credits or Excessive Deductions
The IRS may take a second look at your return if your deductions, losses, or credits are disproportionately large compared to your income or other returns similar to yours.
Additionally, just claiming certain deductions, credits or losses is enough to make the IRS stop and take a look. Here are some of the things the IRS pays extra attention to:
- Refundable credits like the Earned Income Credit, Child Tax Credit, and the American Opportunity Credit
- Large losses from gambling, sale of real estate, rental properties, and investments.
- Home Office Deductions
- Unreimbursed employee expenses
- Claiming a hobby as a business or taking a loss on a hobby
- Claiming the Foreign Earned Income Exclusion or the Research and Development Credit
- Alimony Deductions
- Large charitable deductions, medical expenses, or other itemized deductions
Keep in mind that if you qualify for a deduction or credit you should take it! Don’t let the fear of audit make you pay more tax than you should. Just make sure you keep all the receipts and document in detail anything necessary to prove your right to the claim.
5. Cryptocurrency Transactions
When it comes to cryptocurrency, the IRS doesn’t hold back. They even went to federal court to gain access to Coinbase’s customer data. And yes, Coinbase sends 1099s if your crypto rewards or staking was over $600.
Failing to properly report your crypto earnings could land you in hot water. Cryptocurrency is considered property by the IRS, so it is subject to capital gains tax. If you receive crypto as a form of payment, it is a taxable transaction. Even mining bitcoin is taxable so it is important to familiarize yourself with the taxation of crypto or consult with a professional who does.
6. Amending Your Tax Return
If you realize you made an error on your tax return, but it has already been filed, you will need to amend your tax return. Sometimes you need to amend your return for a simple reason (typo or math error) that doesn’t result in a major change. But, if you make a change (such as claiming a deduction or credit) that results in a larger refund or reduction in tax, the chances of an audit go up.
You still need to amend a return if your original one was incorrect. Just make sure you have proper documentation and reasoning for doing so. The IRS may ask to you clarify or justify your new tax positions, so it is in your best interest to already have that prepared .
Keep in mind, just because you amend a tax return doesn’t mean the IRS will accept it. They will look at your explanation for why you are making changes and decide to accept or reject the changes. This is when they can also decide to conduct an audit.
7. Non Filing
What happens if you just don’t file a tax return? As we mentioned earlier any income you receive on a W2, 1099, or K-1 is also reported to the IRS. So, if you have reportable income you need to file.
If you don’t, the IRS can file the tax return for you in a process called Substitute for Return or SFR. You do not want this to happen. They will take the information reported to them about your income and compute the tax due at the highest tax rate and without deductions. This can oftentimes result in a tax bill much higher than if you had filed on your own.
You will always be better off filing your own tax return, rather than having the IRS do it for you. If you are unable to file your return by the deadline you should request an extension for time to file. This can be done by filling out IRS Form 4868.
8. IRS and State Tax Returns Don't Match
Federal and State taxing agencies can and often do share information with each other. If your federal tax return doesn’t match your state one then you could be in for an audit. Additionally, an audit on the federal level can trigger an audit on the state level and vice versa.
Most of the time taxpayers and professional tax preparers will use one software to file both their state and federal returns, so all information is included on both. But there are some circumstances in which you may file each separately. This can happen when a taxpayer lives in one state but works in another or several states or has self-employment income and using just one software isn’t enough. It’s important to cross reference all your returns to make sure you’ve included everything on all the returns.
9. You Have Been Audited Before
If you’ve been audited in the past and that audit resulted in additional tax due, you could have a higher chance of being audited in the future.
Additionally, if a related entity is under audit that could lead to your personal tax return facing scrutiny as well. A related entity is anyone or business that can be connected to you. This could be a business partner, spouse, or any other business you own. If one is audited, it’s likely the rest will follow.
Another consideration is your tax preparer. Unfortunately, there are tax preparers who don’t mind bending or flat out breaking the law in order to reduce tax liability or increase refunds. Eventually, they get caught and then the IRS has reason to look into all the returns they prepared. Make sure you use a credentialed preparer when having your taxes prepped. All professionals who prepare tax returns for a fee must have an active PTIN number at a minimum. Doing your due diligence ahead of time can save you a lot of headaches later on.
10. Large Changes In Income
There are many reasons your income may vary from year to year. Maybe you got a new job, are self-employed, or got lucky at the casino. But if your income varies widely each year on an ongoing basis, the IRS may want to take a closer look.
The IRS will check the source of all income reported on your W2s and 1099s. If your income change is due to a new job, this can easily be verified as each employer’s EIN is reported on the W2. But if you have many different sources of income or large inconsistencies year to year, the IRS may question if you are reporting all your income every year. The IRS may decide to not only audit one tax year but multiple tax years to make sure nothing was left off or hidden.
11. Foreign Bank Accounts and Income
Owning a foreign bank account, earning foreign income, or taking the Foreign Earned Income Exclusion is something that can increase your chances of an audit.
You can own a bank account in another country, but you are still required to report all income if you are an American Citizen. Some foreign banks report a list of their American clients each year. If you’re on that list and don’t report the bank account yourself you could be in trouble. The IRS can also summon financial statements from the bank directly.
Taxpayers who earn income abroad can sometimes claim the Foreign Earned Income Exclusion if they meet the requirements.
Generally, you must be a bona fide resident of another country for the entire tax year. You may also claim this credit if you were physically present in a foreign country for at least 330 full days during a 12 month span.
Workers who earn income outside of the US, but who do not meet these requirements won’t be happy with the results of an audit if they claim this exclusion. Make sure you read all the rules on foreign income or consult with an experienced tax professional before excluding any income.
12. Early Payout From Retirment Accounts
There are many reasons why you might be forced to take an early distribution from your retirement account. After COVID 19 more Americans than ever before did just that. It’s important to know that when you take an early distribution it is subject to income tax and possibly a penalty tax of 10%.
There are some exceptions to this 10% penalty that the IRS allows.
If you take the early distribution to pay for large medical bills, if you are a qualified first-time home buyer, or totally and permanently disabled you may be exempt from this penalty.
If you don’t qualify for one of the exemptions the IRS outlines here, then you will be responsible for paying the penalty and income tax on the distributions.
The most common mistake people make when taking these early distributions is paying one of these taxes but not the other. Oftentimes the 10% penalty is withheld from the distribution by the bank or financial institution. Taxpayers believe that all the tax has been paid when in truth only part of the tax was withheld.
Because of this dual taxation, taxpayers who take an early distribution may find the IRS wants to double check the return.
13. You Are Self Employed
There are several red flags you need to be aware of specifically if you are self-employed. Here are some of the most common things to watch out for.
Claiming 100% use of a vehicle for business purposes only is risky. The IRS knows it is highly unlikely that you used a vehicle exclusively for business, especially if you don’t have another vehicle available for personal use. Heavy SUVs and large trucks are also targeted because of more favorable depreciation and expensing write-offs. If you are going to claim 100% use, be sure to keep detailed records including mileage, dates, and purpose of vehicle use. This also applies if you use the mileage rates to calculate your deduction instead of using the actual expenses.
Taking large deductions for meals, travel, and entertainment expenses can also set off alarms. IRS agents will look at your profession and compare it with others in the industry. If your expenses are higher than average, you’ll need to be extra diligent when it comes to record keeping. Keep detailed notes as to the date, time, amount, and business purpose of the expense. Document who was there and what you discussed. If you don’t, the agent may decide it was a personal expense and disallow the deduction.
Operating a cash based business can make it easier to overstate your expenses and under report your income. However, the IRS uses several strategies to determine if you are reporting accurately or not. They will use the expenses you report to determine what your income should be. They will also compare it to similar businesses in your area. The IRS can even look into your personal life and see if your lifestyle matches the income reported. Laundromats, bars, car washes, nail salons, and other cash intensive businesses need to be prepared for an audit at any time.
Reporting large Schedule C (Business) losses is another red flag. Doubly so if the loss is large enough to offset other income on your return such as income from a W2. Some W2 earners try starting a business only to offset their current tax liability. They end up deducting passive losses against active income. This happens when they don’t meet the material participation and other requirements established to differentiate between hobbies and businesses.
Other questionable Schedule C losses are those claimed as a day-trader. Since day-traders get special tax advantages over investors any losses or expenses claimed on a Schedule C will be examined more carefully.
Bottom line, being self-employed allows for all sorts of deductions and expenses to be taken. But the IRS knows many self-employed individuals exaggerate their deductions and fail to report all of their income. So it is extremely important to substantiate every expense and record a paper trail of evidence to back up your claims.
So What Do I Do If My Return Has Red Flags?
The most important thing you can do is be prepared. Ask yourself, what questions or concerns would you have if you were the IRS? Ask yourself does my return make sense? If not, why? What is my reasoning for the positions I took? Then prepare your answers now, before the IRS starts the audit. The best chance you have of making it through an audit unscathed, is to respond to the audit concerns promptly, clearly, and accurately. Present your answers and evidence in a way that is easy for the IRS agent to understand and relevant to the case at hand. If you postpone responding to the audit or give unorganized evidence, it could appear like you are hiding something. This may cause the IRS agent to dig deeper, ask more questions, and ultimately increase the chance your audit will end unfavorably.
For every expense you claim, take detailed notes on why the expense is ordinary and necessary for your line of work. If you are using vehicle mileage to calculate an expense keep an updated log of the locations you drove to and why. Try to do this as frequently as possible. The IRS is far less likely to accept a reconstructed log written a year after the fact than one that was updated on a weekly basis. This goes for your bookkeeping records as well. Keep them updated on a weekly or monthly basis.
For any deductions or credits you may claim, keep a copy of all supporting documents together. Know what are the requirements for taking the credits you did and make a note of how you meet them. For example, if you are claiming the refundable American Opportunity Credit for yourself or a dependent, keep a copy of the school transcripts for that year to show the student was enrolled at least part time. Also, keep a copy of any receipts for books and supplies purchased.
You need to go through each expense, deduction, credit or loss claimed and save some sort of documentation to provide as evidence in the event you get audited. This may seem excessive or tedious, but as the saying goes, it’s better to have it not need it than need it and not have it. The good news is you don’t need to submit these documents with your tax return. You only need to keep it for your records if you are audited. You can save the physical evidence or scan it into a computer and save it digitally. The IRS accepts digital evidence with the same credibility as the physical copy.
What To Do If You Are Audited
If you find yourself under audit, don’t panic. Of the 738,000 audits the IRS closed in FY 2021, over 13,000 taxpayers said they disagreed with the IRS determination. The IRS is not perfect and they can make mistakes. Sometimes they simply need further documentation or answers in order to close the audit.
The best thing you can do is consult with a professional. You wouldn’t go to court without a lawyer to represent you and the same goes for the IRS. IRS Agents are experienced and know how to apply pressure using effective fear tactics that leave taxpayers shaking in their boots. But you don’t have to face them alone.
Our professionals at Tax Saver Service are second to none when it comes to representing taxpayers before the IRS. We will handle your case expertly and efficiently. We will help you throughout the process with all necessary paperwork. We will take you through all the steps necessary to complete your audit and get you back to your life. Contact us today for your free consultation and let us get to work for you.
