Updated for 2015
Fortunately, the IRS does not audit the majority of people. Even better, for some people, the less money that they earn, the less they are likely to be audited by the IRS.
According to statistics from the IRS, for the Tax Year 2011, roughly 1.02% of small businesses, 17.64% of large businesses and 0.42% of S-Corporations, 0.4% of partnerships and 1.11% of individuals received an audit from the IRS.
And, in fact, IRS audits have declined in the last 5 years, dropping 22%, with a corresponding 22% drop in IRS agents, according to IRS Commissioner, John Koskinen in this November 2015 Fiscal Times article.
However, there is still some risk for anyone, despite the overall professional nature of the IRS, an audit is rarely an experience to be enjoyed. To avoid or survive an audit from the IRS, you should make sure that you avoid these things that can trigger attention from the IRS.
The majority of taxpayers want to know why the IRS started an audit or whether certain actions might trigger an audit in the future. These concerns are valid, since the IRS rarely takes a random approach to deciding which businesses and individuals to target and instead performs risk assessment.
An IRS audit can be a scary situation. Fortunately, just a fraction of tax returns are audited by the IRS. If you are trying to decide if your return will be audited by the IRS, it is not some magical formula. In fact, the red flags for the IRS are typically well-known.
Here are the top tax return warning signs that you should be aware of and some tips on how you can avoid getting selected for audit by the IRS.
Some red flags are guaranteed to draw attention from the IRS. Some are easy to avoid. Other red flags can't be avoided.
The Internal Revenue Service uses a combined method of automation and human processes in order to decide when a tax return should be selected for audit. All of the tax returns are compared with statistical norms. However, those returns that display anomalies are reviewed by personnel that perform three layers of reviews.
The audits then are done by mail or via meetings at the place of business of the taxpayer. They can be quite unpleasant and are an unavoidable encounter.
1. You Failed to Report All Income That Is Taxable
The IRS will receive your 1099s and W-2 forms that you receive. Therefore, you should make sure that you keep a report of all of the income that appears on your return. The IRS does good job of determining what the numbers should be based on the income on your return. An amount that does not match up will be considered as a red flag and will cause the IRS computer to trigger a bill. If you have received a 1099 that shows income that doesn't belong to you or lists income that is not correct, you should make sure that you file a form with the correction with the IRS.
2. You Have a Small Business
Schedule C offers many tax deductions for people that are self-employed. However, it is a good place for an IRS agent to start because they know that self-employed individuals are known to claim deductions and may fail to report all of their income. The IRS reviews both sole proprietorships at all income levels.
Some scrutiny is also given to businesses that deal mainly with cash transactions (taxis, bars, restaurants, car washes, hair salons, and similar establishments) as well as the small business owners that have reported a net loss on Schedule C that is substantial.
Certain small businesses also have a higher likelihood of being audited as the IRS decides to stop auditing regular corporations. The IRS has decided that it can get better results by focusing on S corporations and small partnerships and limited liability companies. As a result, it has been spending more time on training examiners about issues that are commonly found with entities that are pass-through.
3. Claiming a Home Office Deduction
The IRS has paid more attention to returns that include claims for a home office because it has typically found success in reducing the deduction. Your audit risk rises if you take this deduction on a return that reports a Schedule C loss and/or shows that there is income from wages. If you are qualified for this saving, you can deduct a percentage of your rent, phone bills, real estate taxes, utilities, insurance and other costs that are properly allocated to the home office. That's a good deal.
As another option, you can used the simplified option to claim this deduction: The write-off may be made on a standard rate of $5 per square foot up to a maximum deduction of $1,500.
In order to take advantage of this tax benefit, you are required to use the space especially for business and often as your main place of business. This makes it hard to claim a guest bedroom or children's playroom as a home office, even if this space is also used for work purposes. "Exclusive use" means that the area is only used for trade or business, not also for the family to enjoy hanging out when you are not working.
4. Claiming Business Use for a Vehicle
In a similar way to the deduction for your home office, claiming that a vehicle is used for business is a treasure trove for the IRS when deciding to select certain tax returns for audit. This does not mean that a vehicle should not be claimed for use if it is valid. However, you should be very wary of claiming 100 percent business use for a vehicle.
Only a few individuals are successful at claiming 100 percent business use for a vehicle that they have purchased or currently lease. Therefore, make sure that you maintain good records on how the vehicle is used.
The IRS may decide to do an audit of your business based on the information that was provided during the audit of a third party, or because the IRS received a referral from another internal party, or other government organization or informant. Sometimes family members that are no longer in contact with the taxpayer may decide to share information with the IRS, including spouses that want to obtain leverage for the purposes of a family law dispute.
6. You Earn Too Much Money
Although the overall individual audit rate is only roughly one in 116, as your income grows, the odds of an audit increase. The IRS statistics for the year 2014 indicated that people that make over $200,000 or more have an audit rate of 2.71% or roughly one out of every 37 returns. Report income of $1 million or higher? You have a one-in-13 chance that your return will receive an audit. The audit rate for taxpayers that make less than $200,000 is much lower. Only 0.78% of these individuals received an audit during the year 2014, and almost all of these exams were done by mail.
7. Math Mistakes
Your income tax return will be put into an IRS computer. If you made a math mistake, the computer will already highlight your return for further attention. This is why if you have submitted your own return, it could be a good idea to use tax software in order to make sure that the math on the return is correct.
8. Typos and Entry Errors
It seems like a minor mistake. However, if your numbers don't match up with the numbers that the IRS has in its files, it can raise a red flag. You should even double check the numbers that have been entered by your tax professional.
You are legally obliged to review the information on your return regardless of what the tax preparer has told you. Therefore, you should ensure that you look over your return before the return is sent to the IRS.
Preparers can make you a world of promises. However, when they deduct a bunch of stuff that they shouldn't, you are the one that will be left on the hook with an audit. You will have to repay any money that you have received fraudulently.
9. Your Tax Preparer Is Sketchy
In some cases, your tax preparer may be the reason that you get audited. If the preparer says that you can get a refund that seems unusually high before he or she requests the proper documentation for your deductions and credits, you should be on alert. Get a qualified tax preparer at TaxBuzz.com - look for a TaxBuzz verified badge. They've passed a background check.
10. Not Renting at Fair Market Value on a Residential Real Estate Property
When a rental real estate has property not yielded any income or losses, the IRS may determine that the property is being rented for an amount that is less than the market-value for rent to a non-arm's length person. The IRS may review property tax and interest records in order to determine the value and market rent for the property. Read here: To determine the fair market value of your rental property.
Under typical circumstances, the passive loss rules don't allow the deduction of rental real estate losses. However, there are two major exceptions. If you actively participate in the renting of your property, you have the option to deduct up to $25,000 of loss versus your other income. This $25,000 allowance becomes phased out as soon as the adjusted gross income grows to more than $100,000 and is eliminated entirely once your AGI is over $150,000.
Another exception is for real estate professionals that spend over half of their working hours and 750 or more hours each year materially participating in real estate under the title of a developer, broker, landlord, or related activity. They have the ability to write off losses without any limitations.
11. Differences Between Tax Filing Position and Filing Positions for Similarly Designed Taxpayers and Private Corporations
The IRS may review corporate tax returns among similar businesses; the relationship of purchases, GST/HST and sales remitted to other businesses in the same industry in order to determine if the remittances are reasonable; and the tax returns of the shareholders of the private corporation to the corporation's tax filings.
As a result, for those filing positions that are not in line with the expectations for a particular industry, or which are not in line with shareholders and their private corporations, may trigger an audit.
12. Taking an Alimony Deduction
Alimony that is paid in cash or check is deductible to the payer and taxable to the recipient, under the provision that there are certain requirements. For example, the payments must be made via a divorce or separate maintenance decree or written separation agreement. The agreement cannot say that the payment is not alimony. The payer's liability for the payments must come to an end when the former spouse has died. You'd be surprised how many divorce decrees do not follow these rules.
Alimony does not include child support or noncash property settlements. The rules that determine whether alimony can be deducted are quite complicated. The IRS is aware that some taxpayers who opt to claim an alimony deduction are not always in line with the requirements. It also wants to guarantee that both the recipient and the payer have make proper reports of alimony via their respective tax returns. A mismatch in the reporting by ex-spouses will almost always result in an audit.
13. Misreporting Interest for a Home Mortgage Interest Deduction
Typically, home mortgage interest is the interest that you pay in order to secure a loan on your home (typically a first or second home). The loan may include a mortgage to purchase your home, a second mortgage, a line of credit, or a home equity loan. Taxpayers are permitted to deduct interest from the first $1,000,000 debt on your first mortgage, and an additional $100,000 on a second line of credit or home equity loan.
14. Gambling: Failing to Account for Winnings or Claiming Huge Losses
Whether you are betting or horses or playing Blackjack, you can be assured that the government wants the money that is owed to it. Recreational gamblers are required to report their winnings as other income via the front page of form 1040. Professional gamblers may indicate their winnings on a Schedule C. Failing to report money earned from gambling can draw attention from the IRS, especially if the casino or other venue indicated the amounts on a Form W-2G.
15. Making Charitable Deductions That Are Higher Than Average
One of the perks of looking over millions of tax returns every year is that the government can access statistical data that will reveal behavior that is anomalous. For example, your charitable donations are higher than the average for your income level. Not only should you make sure that you have accurately assessed your charitable donations (such as if you have given away personal property to Goodwill or certain other organizations) but you should make sure that it is done properly – such as filing for 8283 for donations that are in excess of $500.
16. The Earned Income Tax Credit
THE IRS has calculated that roughly 21 percent to 26 percent of EITC claims are paid in error. A portion of the errors are the results of the complexity of the law. However, sometimes these claims are intentional in their disregard for the law.
The EITC's complex rules have resulted in high error rates by taxpayers and even in the case of some paid preparers.
If you or your preparer has claimed the ETC, review the IRS guidelines and make sure that you check to see if you qualify.
17. Claiming a Loss on a Hobby
The definition of a hobby is an activity that is not pursued for the purposes of generating a profit. However, that has not prevented some taxpayers from trying to do a write off of expenses for their dog showing, comic book trading or other type of business.
18. Failure to Report a Bank Account Owned in a Foreign Country Can Result in Major Penalties
You should make sure that if you have any of these types of accounts, that you properly report them. This means that when you electronically file the FinCEN Form 114 to report foreign accounts that are greater than $10,000 at any time during the prior year. For taxpayers that have even more financial assets in a foreign country, IRS Form 8938 may also be required with the tax returns.
What Should You Do If You've Been Audited
What should you if you have been selected for an audit? You should be honest with the auditor and make sure that you reply to any inquiries as soon as possible. Don't be afraid to provide all of the documentation. If possible, you should hire a qualified Enrolled Agent, CPA, or tax attorney to provide you with representation.
If you have been audited, there are some step you can take. First, you should make sure that you reply to any letters that you receive right away. You can request additional time to put together the paperwork and the forms.
The majority of the time, the IRS is simply requesting documentation. However, in some cases, you might decide to obtain representation:
If you can't find the information that the IRS is requesting, you'll probably want to get in touch with a professional for advice. If you have been asked to meet with an agent, you should definitely bring in additional help. Don't start from the position that you are able to negotiate because if you have been deemed to have underreported your income, there is not much room for bargaining. However, once the audit is complete, it can always be appealed, so that they'll make you a deal that will make you satisfied because they don't want to continue with the process. The IRS also offers information on audits and you can complete a Form 911.
Audits will always continue to be a part of the tax collection process. However, it doesn't mean that you have to be among one of the people to be chosen. The trick to avoiding an audit is to be honest, document your deductions, income and donations.
Let us deal with your IRS audit! Give us a call at (855) 829-4475 and let us handle your tax problems.