IRS Red Flags that Put Your Tax Return at Risk for an Audit
Nine Red Flag Warnings
Almost as soon as we finish our tax returns many of us begin to worry about a dreaded IRS audit.
These audits usually involve a letter that asks for clarification, more information, or additional documentation. It will usually be accompanied by a request for payment of additional taxes and possibly interest and penalties. The letter will state why the IRS thinks you owe additional money. It will then be up to you to prove otherwise.
Taxpayers don't usually have to worry about 3 men in dark coats showing up one day at their home to take them off to a windowless office only to have a bright light shined in their face until they to cough up the dough.
What are some of the common Red Flags that can put you at risk for an IRS Audit?
#1 Having a High Income
The higher your income, the higher your risk for an audit. It just goes with the territory.
For all taxpayers, the overall risk of an audit is a little over 1%. Make over $200,000 and it goes up to about 4%. Make over $1,000,000 and the risk increases to about 12%.
Don't try not reporting your income to decrease your risk of an audit. The IRS already has all of those W-2s, 1099s, K-1s, etc that have also been sent to you. If you don't report them, the IRS will know.
Likewise, it probably isn't a great idea to go and ask your boss for a pay cut so that you don't get audited. But, you could increase your contribution to your 401(k) and decrease your taxable income this way.
#2 Not Reporting all of your Income
This falls under 2 categories.
- As I said above, if you receive a W-2, 1099, or K-1, etc., you have to report the income. The IRS already knows about it.
- If you have a business that deals primarily in cash transactions, don't under-report your income just because there isn't always a record of it. Cash businesses in and of themselves are red flags to the IRS. Live in a $300,000 house, drive an expensive car, but report only $25,000 in income from your business, the IRS is going to question how you do it.
#3 Taking Larger than Average Deductions
The IRS knows what to expect for deductions based on your income. Take a deduction that the IRS feels is too high for your income, you may risk an IRS inquiry.
Charitable contributions receives particular scrutiny. All cash donations require receipts for documentation.
The rules for non-cash contributions have become even more stringent. For non-cash donations you have to document how you determined the value of the item you are donating. You can no longer claim a $20 deduction for the old shirt you gave to charity just because you may think it is worth that much. You may have to determine and claim its thrift shop value instead. Some valuable items may require an appraisal to clearly determine their value. For all non-cash donations over $500, you must also file a Form 8283.
#4 Being Self-Employed (Filing a Schedule C)
Being self-employed and filing a Schedule C to report your business income is a potential red flag on at least 2 fronts.
- First, the IRS will want to be sure that you reported all of your income. The IRS will look to see that you reported all income, particularly income reported on a 1099-MISC. If you have a business that deals primarily in cash transactions, agents are trained to look for clues that may indicate that you didn't report all of your income.
- Second, the IRS will closely examine all of the deductions you use to decrease your profit (or increase your loss). Schedule C is full of deductions that will decrease your taxable income. Take deductions that look excessive and you risk an audit.
#5 Taking Excess Business Deductions
- Deductions for entertainment, meals, and travel will be closely looked at by the IRS. You must keep detailed documentation of these expenditures, including the location, the people in attendance, the business purpose and the nature of the discussion. You must have a receipt for any expense over $75 and for all lodging while away from home.
- 100% business use of a vehicle can trigger a red flag to the IRS. While you can claim a deduction for the business use of your personal car, the IRS may feel it is unusual for you to have a vehicle that is used 100% for business. Keep precise logs of mileage, business purpose, and calendar entries to document the business use of your personal vehicle. You can claim the standard mileage rate or actual expenses, but you can't claim both.
#6 Claiming a Home Office
If you run a business out of your home you may qualify for a home office deduction. A home office will allow you to deduct a percentage of your rent or mortgage interest, utilities, insurance, and real estate taxes from your business income.
To qualify for the home office deduction, you have to use an area of your home exclusively for business. Your family can't watch t.v. in the room in the evening and your children can't use your office computer to do their homework.
Beginning with the 2014 tax filing season (for tax year 2013) there is a simplified option for claiming the Home Office Deduction. If you choose this method, you must still use an area of your home (maximum 300 square feet) exclusively for your business, but you will not have to keep all of the records or complete the rather onerous calculations required with the regular method.
With the simplified method, you receive a deduction of $5/square foot of your home used exclusively for business (maximum deduction $1500). If your home office expenses are more, you may still choose the regular method to calculate the deduction.
#7 Claiming a Hobby as a Business
For many, what they do for business is something they enjoy doing. Enjoy photography, go into business as a photographer and get to deduct the cost of your camera and your expenses. Sell a picture or two and your home free. Sounds like a great plan. Maybe not so fast.
The IRS allows you to deduct expenses for a legitimate business, but not for a hobby. If you claim a hobby with a lot of expenses and large losses, such as car racing, as a business, you run the risk of an audit.
You must report any income you earn from a hobby, such as the sale of a few pictures if you are a photographer. But, you can only deduct your expenses to the extent of the income you generated from the hobby. You cannot deduct losses.
To be a business, the activity must have an expectation of making a profit and it must generate a profit at least 3 out of every 5 years.
#8 Multiple Rental Properties
If you have rental property and you actively participate in the management of it, you can claim a deduction for up to $25,000 in losses. This deduction phases out for incomes over $100,000 and disappears when your income exceeds $150,000.
If you can prove you are a real estate professional (developer, landlord, broker, etc.), there is no limit to the losses you can deduct.
Don't claim to be a real estate professional when you are not. The IRS will find out about your real day job.
With increased e-filing, fraud has significantly increased and risen on the IRS radar screen. Tax refunds have been delayed in part because of new IRS screenings for fraud.
- Taking credits that you are not entitled to. Claiming the Earned Income Tax Credit with a qualifying child who is not your own child could raise some red flags. There were a lot of people that claimed the First Time Homebuyer Credit a few years ago that were not entitled to it, including one 4 year old.
- Increasing or decreasing your income to increase your Earned Income Tax Credit. By the nature of the EITC, it increases as your income increases to a certain point and then as your income increases further, your EITC will decrease. There are taxpayers that will manipulate business income to hit the sweet spot of a maximum credit. I wouldn't want to get caught doing this.
- Filing false tax returns. The IRS is aware of identity theft to obtain social security numbers that are then used to tax file returns and fraudulently claim a refund. This year, at least one client in our tax office had a fraudulent tax return filed under her social security number.
Don't be afraid of Red Flags:
- Report all of your income.
- If you can prove you are entitled to legitimate deductions, take them.
- Keep good documentation to justify your deductions.
- Save your receipts to verify your expenses.
- Don't take deductions or claim credits you are not entitled to.
Red Flags, Do You Take Warning?
What type of taxpayer are you?
Any federal tax or tax planning information provided above or linked to this article is not meant to be specific to any particular individual or situation. Anyone who wishes to apply this information should first discuss it with an accountant or tax professional to determine its appropriateness or how it specifically applies to their unique situation.
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