IRS Audit Red Flags and How to Avoid Them
The IRS receives millions of tax returns each year from individuals, married couples and businesses. The IRS is constantly on the lookout for people who might be flouting tax rules by underreporting their income, claiming deductions and credits that don’t apply to them or partaking in an array of other tax-dodging techniques. With such a high volume of returns being received each year, it’s easy to think that your chances of being audited are slim. Think again. The IRS has set up a filter system in which certain items on your tax return will trigger an alert, or “red flag,” which alerts them that something may not be right with the information provided. Although you may feel fully confident in the way you return is looking, you may still be audited if your return has any of these 10 red flags. Listed below are the red flags to try to avoid:
1: Self-Employment Deductions
Being self-employed does not only mean that you can secretly being working at home in your pajamas. It also means that you could be audited faster than others because you may be claiming deductions and business expenses that are not actually related to your self-employment. It might not seem fair, but being self-employed can raise red flags for the IRS, especially if you claim your home office and other costs as business expenses but don’t actually earn much income. Want my tip on how to avoid this audit? Never mix personal expenses and business deductions. Report all taxable income and file the correct tax forms. Keep careful track of all paperwork so you can defend any deductions and credits you take. By doing this, you should not have anything to worry about.
2: Out-of-Proportion Income Figures
Be aware that the IRS has taken great pains to know what the median average wage is for the job that you have. If your income figures are out of proportion to how much other people in the same industry are making, the IRS will be curious and want to know why. Want my tip on how to avoid this audit? Simply just be honest with how much you really make. Lies will most likely result with you being on the IRS radar every time you file your returns.
3: Tip and Cash Earners
If you are a tip earner and/or get a significant portion of your income in cash, you may be more likely to be audited. Cash payments have to be reported on your tax forms although it may be difficult to keep track of your cash/tip wages. It is known that the IRS will more frequently audit certain professions that accept cash and tips. Want my tip on how to avoid this audit? If you work in a cash industry, keep a tip/cash journal. This could save you if there is a dispute. Always answer truthfully and keep meticulous accounting records.
4: Home Office Deduction
The home office deduction is another red flag to the IRS due to the fact that they have strict guidelines on what actually qualifies as a home office. People tend to include their entire home for the deduction. While plenty of people can legitimately claim home office expenses on their taxes, other people do so incorrectly. Merely checking email from home after work, for example, does not justify a home office deduction. In order to qualify, the home office must be used for work only. Want my tip on how to avoid this audit? Your home office must be exclusively used for business purposes and not for any other activities. Read IRS Publication 587 to ensure you qualify for the home office deduction. Always maintain a pristine paper trail so you can easily explain yourself if asked.
5: Business Losses For Self-Employed or Sole Proprietor Taxpayers
Business losses for the first one or two years are common when you are self-employed or a sole proprietor. If you are claiming losses three years later after being in business for 5 years, the IRS will begin to wonder if you really own a business or if you are just writing off a hobby to get more deductions. The IRS tends to look extra closely at taxpayers reporting businesses on Schedule C forms because there tends to be more room for fudging. Want my tip on how to avoid this audit? Have ALL of your business documentation so you can prove that your profit and loss. If you own a business, report every single bit of income you have received. If you’re still worried about being audited, you may even want to reorganize your business as a corporation or partnership (which means you’re not required to file a Schedule C) instead of a sole proprietorship.
6: Making An Income of $200k or Higher
It is just a fact of life that the more money you make, the more likely the IRS will audit you. People will make more mistakes or underreport the amount they made on tricky tax returns when they are in higher income brackets. In addition, the IRS will get a higher payoff when auditing these returns. While there’s not much you can, or probably even want to do about having a high income, you should be aware that for incomes over $200,000, the audit rate is almost four times higher than the national average. Want my tip on how to avoid this audit? Like stated before, it is imperative to report all your income and to keep documentation substantiated your expenses claimed.
7: Failing to Report All Taxable Income
It is easy to misplace a decimal point or add an extra number that would throw off all of your income figures. Failing to report all your taxable income on your return will raise a red flag. The IRS receives copies of W-2s and 1099s from financial institutions and employers and matches the pertinent ones with what is reported on your return. If you have multiple sources of income, you might overlook some, but these businesses will send necessary tax information to the IRS. Want my tip on how to avoid this audit? If there is an error on your W-2 or 1099, have the employer send the IRS the corrected information. Keep track of all income, as unreported sources are likely to trigger an audit.
8: Taking Higher-than-Average Deductions
It is easy to try to claim as many deductions as you can to get a bigger tax refund. But, if the deductions are too large in comparison to the amount you earn (such as claiming $17,000 in expenses but only reporting $23,000 in gross income), an audit will happen. Want my tip on how to avoid this audit? If you can claim the deduction and have the documents to back it up, then put it on the return. Don’t take a deduction that you can’t prove.
9: Taking EITC Tax Credits
The Earned Income Tax Credit (EITC) is a subsidy given to low-income working families. You may be audited if you receive this tax credit but actually make more than the eligibility requirements. Last year, the IRS said tax returns that claim the Earned Income Tax Credit are twice as likely to be audited. According to the Wall Street Journal, “improper claims” of this credit cost the government over $10 billion a year. Want my tip on how to avoid this audit? ONLY take the credit if you qualify as a low-income family or low-income individual. Be sure to read the IRS Guidelines and double-check that you qualify.
10: Taking Large Charitable Deductions
Giving to charities will always be a worthy endeavor. But if your charitable deductions seem abnormally large, especially in comparison to how much income you earn, someone from the IRS will come knocking on your door. The IRS is always on the lookout for people who inflate their charitable donations. Want my tip on how to avoid this audit? Keep all receipts and records of donations so you can explain any deductions that you claim. Have all your documentation and receipts available if you give more than $250. You will need to file Form 8283 for charitable deductions of $500 or more. So, what do you do if you’ve been audited? Any communications with the IRS can be stressful, especially when dealing with IRS auditors.
Feel free to peruse our other audit blog posts, including our IRS audit survival guide for more tips on handling your IRS audit. If you would like a tax attorney and CPA to handle your IRS audit, feel free to call us at 619-795-8000 and schedule a free consultation. As always, conversations with our tax attorneys are privileged and confidential.