The IRS audits only slightly more than 1% of all individual tax returns annually. However, the chances of being audited increase depending upon various factors, including your income level. This blog post will discuss the top red flags that trigger an IRS audit so as to warn taxpayers of situations that increase the chances of drawing unwanted attention from the IRS.
1. Not reporting all of your income
The IRS gets copies of all 1099s and W2s you receive. Thus, the agency matches all reportable items to a person’s return. A mismatch sends up a red flag and causes the IRS computers to issue you a bill.
Therefore, you must make sure you report all required income on your return. Even if you receive “money under the table,” you must report this income as well or you risk the agency finding out and nailing you for tax evasion.
2. Making too much money
While only 1% of the overall population gets audited, 2012 IRS statistics show that people with incomes of $200,000 or higher had an audit rate of almost 4%. The probability of being audited increases to 21% for taxpayers with income over $5 million and to 30% for those earning $10 million on more.
A reasonable explanation for such discrepancy is that higher incomes are likely to result in more complex tax returns that are more likely to contain audit triggers. Most importantly, the IRS wants to maximize return on investment, and as such, taxpayers must be careful when preparing their taxes because the more income you show on your return, the more likely it is that you will be hearing from the IRS.
3. Failing to report a foreign bank account
The IRS is intensely interested in people with offshore accounts, especially those in tax havens, and tax authorities had had success getting foreign bank accounts to disclose account information. The IRS has also used voluntary compliance programs to encourage taxpayers to disclose their foreign bank accounts in exchange of reduced penalties. Failure to report a foreign bank account can lead to severe penalties, and the IRS has made the issue a top priority.
Taxpayers must indicate in their return the institution and the highest dollar amount the account was at the previous year. Those who have foreign assets worth $50,000 or more must also attach Form 8938 to their timely filed tax return.
Moreover, indicating on your return that you do business in foreign countries or take many trips abroad for work could also raise red flags if no foreign assets are reported.
4. Taking large charitable contributions
When charitable deductions are disproportionately large compared with your income, it raises a red flag. That is because IRS computers know what the average charitable donation is for people at your income level. Also, if you do not get an appraisal for donations of valuable property, or if you fail to file Form 8283 for donations over $500, the chances of audit increase.
As such, if you report high charitable contributions make sure you have the proof to back it up.
5. Claiming the home office deduction
The IRS is drawn to returns that claim home office write-offs because it has found great success knocking down the deduction and driving up the amount of tax collected for the government. To take advantage of this deduction, you must use the space exclusively and regularly as your principal place of business. Just because you do some work on your couch while watching TV does not mean it counts as home office.
In order to avoid being audited, make sure you claim reasonable expenses, and only those that directly apply to the part of the home used as an office.
6. Claiming 100% business use of a vehicle
The IRS knows that it is extremely rare for an individual to actually use a vehicle 100% of the time for business purposes, especially if no other vehicle is available for personal use.
To avoid raising a red flag, list on Form 4562 only the percentage your vehicle was used for business purposes during the year. Make sure you keep detailed mileage logs and precise calendar entries for the purposes of every road trip, in case you get audited.
As a reminder, if you use the IRS’ standard mileage rate, you cannot also claim actual expenses for maintenance, insurance and other out-of-pocket costs. Claiming both deductions is a red flag and your chances of being audited increases.
7. Running a cash business
Those who receive primarily cash are less likely to accurately report all of their taxable income. As such, small business owners involved in cash-intensive business, such as taxis, car washes, bars and alike, are often a target for IRS auditors. The IRS has a guide for agents to use when auditing cash-intensive business, telling how to interview owners and noting various indicators of unreported income.
8. Taking higher than average deductions
If deductions on your return are disproportionately large compared with your income, the IRS is likely to audit you. Thus, make sure to claim reasonable deductions. But, if you have the proper documentation for your deduction, do not be afraid to claim it.
9. Deducting business meals, travel and entertainment
Big deductions for meals, travel and entertainment are always an audit red flag. Agents are constantly on the lookout for personal meals or claims that do not satisfy the strict substantiation rules.
To qualify for meal or entertainment deductions, you must keep detailed records that document for each expense the amount, place, people attending, business purpose and the nature of the discussion or meeting. Also, you must keep records for expenditures over $75 or for any expense for lodging while traveling away from home. Without proper documentation, your deduction raises a red flag and your chances of being audited increases.
Please keep in mind the information and advice presented in this blog is not intended to be used as formal legal advice. Contact a tax professional for personalized tax advice pertaining to your specific situation. While we try and answer all parts of the question when we write our blogs, sometimes there may be some left unanswered. If you have any questions about your problems with the IRS, SBOE, FTB, or BOE, or tax law in general, call RJS Law at (619) 595-1655.