The odds of being on the business end of an IRS tax audit are pretty low. According to its 2019 Data Book, the Internal Revenue Service (IRS) has conducted fewer audits every year over the past decade. In 2019, they only audited 0.4% of taxpayers. However, whether you get audited isn’t determined by chance alone.
Specific actions are IRS audit red flags, which can raise or reduce your odds of getting audited. So what can you do to prevent an audit? Read on to learn 16 IRS audit red flags and how to avoid them.
IRS audit red flags
Keep in mind, having an IRS audit of a red flag in your tax return isn’t necessarily a problem. If you do get audited, all you need is the appropriate paperwork to prove that your claims are legitimate and accurate. That’s why it’s important to keep rigorous files on your income and expenditures every year!
When you do your taxes this year, these things could catch the eye of the IRS. If these are on your report, make sure you have the documentation required to prove your case if the IRS decides to audit you.
Failing to report income you made from a side-gig might sound harmless, but the IRS knows exactly how much you made this year. When you earn income, your employer generates a W-2 (for wage earners) or 1099 (for non-wage income).
When tax season rolls around, the IRS receives copies of each of those forms. This makes it virtually impossible to get away with underreporting your income.
Of course, legitimate credits and deductions can reduce your adjusted gross income. But if there’s too big a disparity between the figure the IRS receives and one you report, that’s a major red flag.
Too many deductions and credits
If you make 50,000 dollars per year, and your deductions total 45,000 dollars, the IRS may have a few questions. Of course, this doesn’t mean that you shouldn’t claim every penny to which you’re legitimately entitled. What it does mean is that you should maintain meticulous paperwork to back up your claims because you’ll probably need it.
Are you claiming too many credits to try to chip away at your tax debt? There’s a better way. Click here to learn about tax relief solutions.
Excessively generous charitable contributions
The IRS knows what most households at your income level donate to charities every year. If you claim a lot more than the average deduction, you are likely to draw their attention.
Again, if you have the proper paperwork to back up your claims (especially Form 8283 for non-cash deductions valued at more than 500 dollars), there’s no problem. Claim every contribution you’ve made – make sure that you have receipts!
Claiming rental losses
If you manage rental properties as a landlord, you can deduct up to 25,000 dollars of related expenses from your income. Real estate professionals (individuals who spend more than half their working hours and at least 750 hours annually acting as developers, brokers, or landlords) get even more significant tax breaks. If you’re a real estate pro, you can write off any losses that you incur without limit.
However, be wary. The IRS examines the returns of taxpayers who claim to be real estate professionals but who also report substantial non-real estate-related income. If this applies to you, be ready to prove the legitimacy of all of your income sources.
Claiming a hobby as a business – use Schedule C as a guide
Do you love taking photos? It’s a beautiful hobby – and an expensive one. But unless you earn a reasonable profit from your picture-taking, you can’t write off your costs as business expenditures. And if you write off costs as business expenditures for a hobby that you’ve never reported a profit on, the IRS may get suspicious.
For the IRS to consider your hobby a legitimate business, a good rule of thumb is that you should report a net profit on your activities at least 3 out of every five years. When you complete a schedule C, you can determine if your hobby is a business.
The full list of factors the IRS uses to differentiate between hobbies and businesses are whether you:
- Carry out the activity in a businesslike manner and maintain complete and accurate books and records.
- Have personal motives in carrying out the activity.
- Put time and effort into making it profitable.
- Depend on income from the activity for your livelihood.
- Have any control over the losses, or they are normal for the startup phase of your type of business.
- Or your advisors have the knowledge required to carry on the activity as a successful business.
- Were successful in making a profit in similar activities in the past.
- Have made a profit after several years in business and how much profit the business makes.
- Can expect to make a future profit from the appreciation of the assets used in the activity.
Stashing money overseas
Maintaining a foreign bank account or offshore bank accounts and financial holdings is not illegal. But maintaining foreign accounts to evade federal income taxes certainly is. Individuals with foreign holdings of more than 10,000 dollars must declare their holdings on FinCEN Form 114 by June 30. Taxpayers with more extensive financial holdings must attach Form 8938 to their federal income tax returns.
Many institutions that formerly operated as tax havens now share intel with the IRS, including their U.S. account holders’ identities. If you fail to report any holdings in a foreign bank account, you’re at serious risk of undergoing an audit.
Claiming 100% business use of a vehicle
If you run a garbage collection agency, the odds are good that your garbage collection trucks are used exclusively for your business. As such, claiming 100% business use for these vehicles is perfectly fine!
If, on the other hand, you use your vehicle to deliver packages, drive for Lyft, or deliver takeout, you cannot make such a claim. You can still claim mileage, gas, and other expenses for miles you drove on the job but be sure to maintain accurate logs if you want to stay in the IRS’ good books.
Inaccurate gambling reporting
You’re a professional gambler and lost big last year. At least your misfortune is a legitimate tax deduction — as long as you maintain sufficient records to back up your claim.
On the other hand, if you score a big gambling win, the IRS will take a cut. Casinos and lotteries report such winnings to the IRS; if you fail to report this income, the IRS audit risk greatly increases.
Whether you’re claiming massive losses without evidence or neglecting to report your winnings, you’re going to get the IRS’ attention. Avoid these IRS audit red flags or face the consequences.
Claiming the home office deduction
If you’re self-employed and you’ve set up a dedicated office in your house or apartment where you conduct business. By all means, claim the home office deduction. The IRS even provides a simplified formula of 5 dollars per square foot, with a maximum deduction of 1,500 dollars. Your home office doesn’t even have to be an entire room! Any space that is exclusively devoted to business counts as a legitimate deduction.
But the keyword here is “exclusive.” If you work at a desk in your bedroom that doubles as a gaming station or set up shop at your kitchen table, you cannot claim this deduction.
Claiming day trading losses
Another major red flag that can trigger an IRS audit is claiming day trading losses.
With the rise of discount brokerages and brokerages with zero commission trades, day trading has become easier than ever. However, the vast majority of people who trade, even if they think of themselves as day traders, are actually investors and do not meet the definition of a day trader.
Being a day trader lets you treat your investment income differently than an investor, which can be advantageous in many ways. For example, day traders aren’t subject to the annual cap on deducting trading losses from regular income when filing their taxes.
This makes the IRS scrutinize filings from people who claim day trading losses very closely, making them a prime target for an audit.
For most taxpayers, your odds of being audited are very low. But for taxpayers with very high incomes, those odds go up. Having a lot of money and making a lot can be red flags to the IRS. Taxpayers with incomes between $200,000 and $1 million had an audit rate of 0.53% in 2017. Households making more than $1 million had an audit rate of 2.21%. And for households making more than $10 million, that rate is a whopping 6.66%.
If you have a higher-than-average income, be ready to prove the legitimacy of your income sources and deductions.
Related: Did you know that if you owe back taxes, the IRS can garnish your wages? Find out how you can stop a wage garnishment by the IRS.
Filing sloppy tax returns
Computers process most federal income tax returns. But if IRS computers get discombobulated by math errors, the IRS calls in an actual human to sort out the mess. Once that happens, your odds of being audited increase dramatically. To avoid this situation, consider using tax preparation software that checks for math errors and omissions.
Besides math errors and commissions, look out for common mistakes like entering the correct social security number. Ensure the digits of the social security number or tax identification number are entered correctly on the forms.
Round your numbers
Yes, rounding your income to the nearest hundred will make the math easier, but it’s not worth it. Too many round numbers raise suspicion that you may be shaving off taxable income. Break out the calculator and include the exact figures when you prepare your return.
Steak dinner with your clients
According to the IRS, you can deduct “non-entertainment-related meals” as a business expense. However, they must be directly related to your trade or business, and the IRS must deem them “ordinary and necessary expenses. That means a luxurious night out with your clients probably won’t qualify.
The rules that govern this deduction are strict, so it’s a good idea to read up on them before asking the government to pay for your drinks.
Every year, people deliberately try to cheat on their tax returns. The IRS is aware of the wide variety of fraudulent tax return schemes, so the odds of getting away with tax fraud or tax evasion are not in your favor.
Even if you do escape prosecution for a year, the statute of limitations for tax evasion can extend for decades, depending on how the IRS frames the charges. That’s a long time to have the IRS looking over your shoulder.
You received an IRS audit notice…now what?
First, get your information straight. Here are some steps you should take.
- Know what type of IRS audit you are facing. A correspondence audit, office audit, or field audit. If you are facing a field audit, contact a tax professional.
- Respond within the given time frame, usually 30 days. Failure to respond can result in losing the right to dispute the IRS’ claims.
- Prepare your documents. You will need all of the 1099s and w-2s you received, tax returns, and verification of charitable deductions. Business owners will need proper documentation of their business expenses. Proper documentation would include proof of losses claimed for self-employment tax paid, detailed records of any claimed meals, travel, and entertainment expenses. Make sure you are only claiming allowed deductions.
- Evaluate your need for a professional tax representative.
- Make sure you are knowledgeable about your rights as a taxpayer.
- Know the statute of limitations. The IRS knows the rules, but most taxpayers do not. The statute of limitations for an audit is three years, except in cases of fraud or significant underreporting.
- The IRS gets to ask the questions. Answer all questions honestly, but do not offer information. Keep detailed records and let if you hear from the IRS, let your documentation do the talking.
- Be professional. Take the IRS seriously, don’t postpone or fail to show up for meetings.
- Negotiate tax issues if you disagree with the auditor. (This is another argument for having a tax attorney or other tax professional in your corner).
- When IRS gets finished with the audit, you can question the results and appeal the results if necessary. Find out more on what to do when you disagree with the IRS here.
For additional detail on these tips for your IRS audit, read this article.
Watch those claimed deductions and losses
Failing to report your income or taking improper deductions results in a red flag on tax returns. It is best to report accurately on all your taxes. Improperly deducting business meals, travel, and other expenses may save money at the moment but will cost you a lot of money when audited. Keep in mind many entertainment expenses do not fall under the cost of doing business. When in doubt, check with a tax pro.
If you are self-employed, keep detailed records of your expenses, losses, and income to include cash transactions. You must report your taxable income to the IRS each tax year. You do not want to find yourself in the IRS statistics as another business owner is penalized for poor accounting.
How do you know if the IRS is auditing you?
Tax season is prime time for scammers who like to pose as the IRS to steal your personal information or even the tax refund you’re owed. You’ve likely gotten a phone call or email from one of these scammers in the past, so you might wonder how you’ll know if the IRS is auditing you.
The IRS informs taxpayers of audits exclusively by mail. Until you get that letter, ignore any phone calls or emails claiming that you’re getting audited.
If your tax return features any of these IRS audit red flags, don’t panic. As long as you have evidence that your claims are legitimate, you have nothing to fear from an audit. If you’re worried, consider hiring a tax attorney to help advocate for you during an audit. Or use tax preparation software to keep your tax return error-free.
And if you’ve accrued a pile of tax debt, tax fraud is not the answer. Instead, it can help to have a tax relief company on your side. The best tax relief companies have tax lawyers and enrolled agents on staff, provide a money-back guarantee and charge competitive rates. Check out which tax relief company is the best fit for you. o