If you are getting ready to prepare your tax return, then you are probably wondering likelihood of the IRS auditing your return. All tax returns are processed electronically, and a full IRS audit has become increasingly rare.
But there is still a small chance that you may be selected for an audit. This chance is greatly increased by various aspects of your tax return, or other suspicious actions or behaviors that are picked up by the IRS’s system.
Many factors can raise red flags that can trigger an IRS audit. We will look at the 10 most common red flags that pop up on the IRS’s radar.
Unsurprisingly, there are a huge amount of math errors made by taxpayers when filing their tax returns. The IRS system is designed to pick up these errors and flag them. Intentional or otherwise, mistakes on your tax return will result in fines.
It is also worth noting that using too many perfectly round numbers will also draw scrutiny from the IRS. Round numbers are usually rare and too many of them come across as suspicious to the IRS, so always use the exact amounts.
The pursuit of non-filers has become a priority for the IRS after they were heavily criticized by the Treasury for slacking in this department. Individuals who made over $100,000 and didn’t file a return are the main targets.
If non-filers fail to comply with collections officers, they are most likely subject to a tax audit, fines, and even criminal charges. Non-filers (especially high earning ones), as well as those who fail to submit their tax return timeously, will have a high probability of being audited
The IRS is extremely good at catching any missing income on your tax return. They have all the information they need regarding your income such as your 1099 and W-2 forms. Their systems cross-reference these records against your tax returns to look for inconsistencies.
With remote working and freelancing on the rise, the IRS is cracking down on income disclosure from these forms of work. If you receive a Form 1099, be sure to file it or the IRS will eventually come knocking.
The odds of being audited increase as your income level rises. Even if there is no clear evidence of underreported income, wealthy taxpayers can expect the IRS to survey their earnings far more closely.
The IRS has been criticized for focusing too heavily on low-income earners while allowing the wealthy to evade tax. This criticism has made the wealthy the primary targets of the IRS.
In the 2016 IRS statistics, taxpayers making less than $200 000 per year were audited 0.65% of the time, taxpayers making more than $200,000 per year were audited 1.7% of the time, and taxpayers making over $1 million were audited 5.8% of the time.
Excessive losses, deductions, and credits
If you claim large amounts in losses and deductions relative to your income, the IRS’s attention will be raised. The types of deductions and losses that you claim will also be looked at, as will the type of business that you operate.
Due to the increasing number of tax credits available to US citizens, tax fraud, especially amongst low-income taxpayers that are less likely to be scrutinized by the IRS, is on the rise. Due to the IRS’s limited resources, some of these false claims go unnoticed, but it is only a matter of time until repeated offenders are caught.
The IRS is usually suspicious of self-employed taxpayers who claim excessive losses under schedule C. The self-employed are entitled to a wide variety of deductions and credits under schedule C.
However, many taxpayers will try to claim for items that are not business-related which the IRS is all too aware of. A business that is performing well, yet claiming losses and incurring unique expenses, might also draw suspicion.
Certain investors and day-traders are also covered by schedule C so significant investment losses and deductions for these individuals are also examined carefully.
Small businesses are also eligible for deductions under schedule C and regularly claim these excessively. Many of these businesses are inexperienced and need money, so they are more likely to misreport their tax returns, sometimes unintentionally.
The IRS focuses its attention on cash-intensive sole proprietorships and partnerships, as well as businesses that report large net losses under schedule C. The IRS gets a significant portion of its revenue from small businesses, so it spends a large amount of its resources on surveying them carefully
Making large charitable donations
Charitable donations are fully deductible, but they are not above suspicion. If you make donations that are excessively large relative to your income, a red flag may be raised.
The IRS has done extensive research into estimating the average donations for various income levels. Significant donations relative to earnings will be noticed.
It is important to get appraisal for donations of property and non-cash donations. Failure to do so will increase the chances of a red flag being raised. Be sure to always keep records of documents relating to any contributions or donations that you have made.
Foreign bank accounts
If you do not thoroughly disclose your foreign bank account to the IRS, you will be scrutinized. The IRS has become stricter and more vigilant of money being stored abroad, especially in regions that are considered tax-havens.
You must file a FinCEN Form 114 by mid-April to disclose foreign accounts totaling $10 000 or more. Those owning other forms of financial assets will also need to file an IRS Form 8938. Failure to supply the IRS these forms will result in a tax audit and severe penalties.
Deductions for rental losses are usually prohibited by the passive loss rules with two exceptions.
If you actively participate in renting out your property, you are entitled to a $25,000 deduction against your other income. Real estate professionals that spend a specified number of hours each year participating in the property can also write off rental losses.
A common issue with this is that many falsely claim to be real estate professionals to write off losses. The IRS investigates the taxpayer’s other income and businesses to determine their professional involvement in real estate. They also examine the number of hours worked on the property, especially amongst landlords who have jobs outside the real estate industry.
The thought of an audit can be unnerving, but it is nothing to fear if you have all of your ducks in a row. If you are honest, open, accurate, and organized, a tax audit shouldn’t be an issue.
The only way to deal with the threat of an audit is to preemptively prepare yourself by keeping meticulous records of your financial transactions. Working with a professional tax preparer is the best to avoid a tax audit as it can be inconvenient and time-consuming. If you have been selected for a tax audit, it is vital to be able to back up your tax claims with strong evidence. If you can’t, it may be worth getting professional assistance.