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Beware: These Tax Return Red Flags Could Catch the Eye of the IRS

by
Gordon W. McNamee
on
2/22/2021
Beware: These Tax Return Red Flags Could Catch the Eye of the IRS

It happens every year. It seems as if we barely have time to celebrate and enjoy the new year and wait to see whether the groundhog will see his shadow when tax forms and statements start appearing in the mail and we realize it’s time to start thinking about filing our tax forms again. The gathering of documents and receipts is already a lot of work, but if you find out that you owe the government money, it can be a real downer. Still, when it comes to taxes, the worst feeling of all happens well after the day that you file, if your mail includes a notice from the IRS that they’ve found some kind of discrepancy that’s made you subject to an audit.   

As much as we’ve all been taught that the IRS is filled with scary tax men and women whose sole job is to smell out every little mistake and then exact punishment upon us, the reality is that tax audits are pretty rare. A recent report issued by the agency revealed that only 0.6% of individual tax returns filed between 2010 and 2018 were subject to an audit, which sounds pretty good unless you were one of the 250,000 taxpayers included in that small group! To decrease your chances of being an auditee in the future, here are some helpful tips about the behaviors and red flags that the IRS uses to signal that an individual tax return requires investigation.

When Your Lifestyle Conspicuously Exceeds the Income You’ve Reported

It’s one thing to live a little beyond your means, but it’s an entirely different thing to report a modest income and then deduct like a high roller. If that describes you, expect the IRS to take a much closer look to see whether the expenses that you’re reporting are real, especially if your income doesn’t match the lifestyle indicated by your deductions. If your mortgage interest deductions, real estate taxes, or personal property taxes reflect Lifestyles of the Rich and Famous but your reported income doesn’t, you can expect the IRS to want to have a little chat.

If Your Generosity to Charity Doesn’t Match Your Income

Giving to charity is a good and noble thing, and it is something that our tax laws incentivize, allowing those who can itemize to take deductions for what they give to those in need. But some people use this deduction unethically, reporting donations that are far greater than their income would allow to lower their tax liability. The IRS has sophisticated software that is programmed to detect this type of disparity, assigning a score called a Discriminate Function to each tax return. If your score is too high, it means that you’ve exceeded their threshold of what’s to be believed. 

When Your Reported Income Differs from the Information Provided by Employers and Others

The IRS does not rely on your 1040 as the only basis for reviewing your tax liability. Just as your employers and others who provide you with income send you tax forms, they submit the same forms to the IRS. If what you put on your tax forms doesn’t add up to the paperwork received from others about what you’ve earned, you can expect to be audited.

Hitting the Exact Number Needed to be Eligible for the Earned Income Credit

Eligibility for the Earned Income Credit is a sort of magic number that provides a significant tax benefit, but to qualify requires a unique combination of numbers and circumstances, and when you’re inputting your income and expense information you either hit it or you don’t. Unfortunately, some people try to manipulate their numbers in order to get to the ratio that delivers the credit, which may be as high as $6,660 for tax year 2020. If your ratio is exactly where it needs to be, it is going to raise some alarm bells within the IRS.

When Your Business Expenses Don’t Make Sense

As a business owner, you are responsible for reporting your income as well as your expenses, and in most cases you’ll be able to take deductions for what you spend to operate your business. Unfortunately, there are some people who try to cover expenses for their hobbies by reporting that it’s a business and taking deductions for what are essentially recreational activities. The IRS will gauge the legitimacy of expenses that are deducted by how much income the “business” is bringing in. If what you’re earning doesn’t make sense based on what you’re spending, they’re likely to want to see what’s really going on.

When Your Itemized Deductions Far Exceed Your Income

Just as is true with charitable deductions, when an individual taxpayer is eligible to itemize and take deductions but their reported expenses are not in line with their income, it’s going to make the IRS take a second look. That’s not to say that your deductions are necessarily illegitimate – the IRS may look at your documentation, see that everything is in order and allow you to take all of those deductions. But you want to make sure that you keep all of your receipts and documentation so that you can be sure to prove that you’re doing everything and spending everything that you say you are. 

To avoid issues, here’s a quick reminder about one area that is putting a lot of individuals in the audit spotlight: As of 2018, employees are no longer able to deduct unreimbursed business expenses on their federal taxes. If you live in California you can still deduct them from your state taxes, but those deductions are no longer available at the federal level.

When Two Taxpayers Both Claim the Same Dependent

There are all kind of tax laws that govern who can and can’t be a dependent, but one way or another only one taxpayer is able to take the dependent write-off for a given individual. That means that if two adult siblings are both providing care for an elderly parent, or two separated parents share custody of the same child, they will need to determine who gets the deduction. When more than one person claims the same dependent, the IRS spots it immediately and it will likely lead to both being audited. If you’re in a situation where you can’t control the other person’s actions but you feel that you are the appropriate person to get the credit, make sure that you have documents on hand for everything from custody arrangements and birth certificates to school records and receipts for care expenses.

Using the Wrong Filing Status

Another issue that can confuse single parents and lead to an audit has to do with choosing the correct filing status, and that is especially true because of changes introduced by the Tax Cuts and Jobs Act of 2017. Where the Head of Household status was traditionally used, the new law introduced a $500 dependent credit for ‘qualifying relatives.’ Trying to determine whether you can get this credit for people not related to you and still determine whether you are eligible to use the head of household filing status is determined by qualifying tests.

Overseas Accounts that Aren’t Reported

Having assets held in overseas accounts is perfectly legal, but U.S. citizens or U.S. residents who have these types of accounts – or even who have interest, signature authority or authority over them — must report them to the IRS if their value exceeds $10,000 at any point during the calendar year. The Bank Secrecy Act makes it a requirement that these holdings be reported to the Treasury Department whether they generate taxable income or not, and their existence is sure to be discovered as foreign financial institutions are required to disclose them. If you hold this type of account, report it using the Report of Foreign Bank and Financial Accounts form also known as FBAR. Failure to do so could have significant repercussions.

Inflated Rental Property Expenses

Owning rental property is a great way to supplement your income, but when you report your rental expenses, be aware that the IRS will be on the watch for Schedule E deductions that seem inflated. This frequently happens when owners are not aware of the different deductions that are permitted, as well as which expenses need to be capitalized. Because there is so much room for manipulation, the rental property expense laws have a lot of confusing specifics, so make sure you know what is allowed and what the requirements are surrounding complexities like renting out a place that you also use as a second home, renting out individual rooms in a property that you occupy, and short-term rentals. 

Questions on Crytopcurrency Transactions

As Bitcoin and other cryptocurrencies have come into increasing use, the IRS is paying close attention to taxpayer failures to report gains and losses. The fact that this innovative currency is largely unregulated does not mean that it is not taxable, and about 10,000 individuals have gotten notices warning that their returns are being watched. Letters went out offering these individuals the ability to step up and disclose their earnings, and the 1040 now specifically asks taxpayers whether they have conducted any virtual currency transactions. As undetectable as these transactions may seem, it’s a good idea to be honest if you’ve been involved, as failure to do so is considered perjury. 

If You’re Audited

IRS audits are disruptive and intimidating, but getting a letter from the IRS doesn’t necessarily mean trouble. If you receive a letter from the IRS, reach out to your tax professional immediately.

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Gordon W. McNamee

Gordon W. McNamee

Gordon W. McNamee is a Certified Public Accountant (CPA) based in Rancho Cucamonga, CA. Gordon W. McNamee can assist you with your tax return preparation, payroll, accounting and tax planning needs. <br /> <br /> 2021 is Gordon W. McNamee, CPAs 38th year in the profession. As as a former IRS agent (1984 through 1987), Gordon has been in public accounting since 1987. Gordon specializes in individual, corporate, HOA, trust, estate and payroll taxes. He also prepares financial statements and provides accounting & bookkeeping services. He enjoys making his clients feel at ease while providing a personalized professional service.

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