What Triggers An IRS Tax Audit?

What Triggers An IRS Tax Audit? | Dallo Law Group

What is an IRS Audit?

An IRS audit is a review or examination of an organization’s or individual’s accounts and financial information to ensure the information reported is correct according to the tax laws and to verify the reported amount of tax is correct. The IRS is double checking to ensure there are no discrepancies in your return.

Preparing and filing a tax return can be stressful enough, so knowing what flags the IRS to audit can save you headache, time, and money. The IRS isn’t going to waste its time on an audit unless agents are moderately sure that the taxpayer owes additional taxes and there’s a good chance the IRS can collect that money. This puts a focus on high-income earners, those who run a cash-heavy business, and those who file fraudulent returns.

  • Being a millionaire isn’t all it’s cracked up to be – the more you earn, the more likelihood you have of being audited. Based on 2019 returns, 1.3 percent of taxpayers earning $1 million to $5 million were audited, according to the latest IRS data. Audits for taxpayers earning more than $10 million reached close to 9 percent. That’s compared with 0.2 percent for taxpayers earning $25,000 to $50,000. Interestingly, that was the same audit rate for taxpayers with income ranging from $200,000 to $500,000. (Source: IRS)

  • Businesses that handle a lot of cash routinely are subject to the scrutiny of the IRS because they may believe underreporting income is taking place, and even more so in situations where workers make tips. Businesses such as; nail salons, restaurants, car washes, and child care should be diligent in keeping meticulous records and reporting their income transactions. Reporting a high volume of cash transactions or large cash transactions may also come under scrutiny for detection of tax crimes and other potential criminal activity.

  • Failing to report all your income is one of the easiest ways to increase your chances of getting audited. The IRS receives a copy of the tax forms you receive, including Forms 1099, W-2, K-1, and others and compares those amounts with the amounts you include on your tax return. If those numbers don’t match up, there’s a good chance an audit is coming your way.

  • It is easy for income to go unreported when your business and personal assets intermingle. Abusing deductions for meals, entertainment, travel and mileage expenses by claiming excessive amounts or failing to allocate personal and business expenses separately can attract the attention of the IRS.

Selection Process for Auditing

The IRS has an examination audit process. Selecting a return for examination does not always suggest the taxpayer has been dishonest or made errors. In actuality, some examinations result in a refund or acceptance of the return without change. Here are some ways the IRS selects returns for audit.

  • Potential participants in abusive tax avoidance transactions – Some returns are selected based on information obtained by the IRS through efforts to identify promoters and participants of abusive tax avoidance transactions.

  • Computer Scoring – The IRS uses the DIF (Discriminant Function System) which gives each return a numeric “score”. The DIF score rates the potential for change, based on past IRS experience with similar returns. The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income.

  • Large Corporations – The IRS examines many large corporate returns annually.

  • Information Matching – Some returns are selected because the taxpayer reports information that does not match the income reported on the tax return. These forms include the W-2 from employers and 1099 interest statements from banks.

  • Related examination – Returns may be selected when they involve issues or transactions with other taxpayers, such as business partners or investors whose returns were selected for examination.

Importance of Keeping Accurate Records to Avoid Suspicion

Gathering and maintaining your business records cannot be overstated. By closely monitoring and thoroughly tracking all your expenses, revenue, and deductions throughout the fiscal or calendar year, your accountant or CPA will be able to fill out your tax return accurately and completely. A well run business is one that has a healthy relationship with banks, creditors and other financial partners. By keeping your financial information updated on these documents, you can reflect where your business stands at all times and monitor progress. All of your documentation throughout the year must match and reflect the information that goes into your return. Without these records, it will be a challenge to assemble the exact figures for your individual or businesses income, profits, losses, expenses, and deductions, which are essential to accurately complete your tax return. When these figures do not match, an audit may be possible.

Document Discrepancies Between Reported Income and Reported Deductions

Reported income that the IRS requires you to declare includes wages, salaries, commissions, strike pay, rental income, alimony, self-employment income, and stock options to name a few. Reported deductions are expenses that can be subtracted from your gross income in order to reduce the amount of income that is subject to taxation. Deductions can be student loan interest payments, educator expenses, self-employed health insurance payments, alimony payments, and contributions to a retirement account. You may trigger an audit if you spend and claim tax deductions for a significantly larger amount of money than most taxpayers in your financial situation do.

Common Red Flags for an IRS Audit

Abnormally High Deductions or Losses Explanation of how claiming unusually high deductions or losses may trigger an audit – A red flag that can cause an IRS audit is claiming high deductions or excessive credits compared to income. For example, if you made $100,000 in a single tax year and claimed $70,000 in charitable deductions. In general, you can deduct up to 60% of your adjusted gross income via charitable donations, but you may be limited to 20%, 30% or 50% depending on the type of contribution and the organization. Also, always keep track of your tax-deductible donations, no matter the amount.

Business Expenses – Take a Closer Look

Home office deduction Working at home does not automatically mean you can deduct expenses related to your home office and related expenses, like utilities. Eligibility for the so-called “home office deduction” is generally limited to self-employed individuals and small businesses. Even then, the deduction will be disallowed if you don’t actually use the space as an office, don’t strictly maintain the space for business use, or don’t otherwise strictly comply with the rules. If you are claiming the home office deduction, the IRS may ask you to prove your expenses.

Claiming a hobby as a business

Writing off expenses for a business is allowable but writing off expenses for a hobby is not. Generally, if you have not shown a profit from your business in at least three out of five years that you operate your business, then the IRS will view your business as a hobby. If so, then you are limited in the amount of your deductions for expenses relating to activities not engaged in for profit. If you are operating a business, treat it as such and ensure you keep proper books and records.

Foreign Accounts

If the IRS suspects that you have $10,000 or more in one or more foreign financial accounts and have not filed a Foreign Bank Account Report (FBAR), or if they believe you misreported assets and income on the FBAR, you may be subject to audit. An FBAR audit can be complex and the failure to comply with FBAR reporting requirements may subject you to civil penalties and criminal prosecution exposure. Foreign Banks are required to report information about you. The Foreign Account Tax Compliance Act (FATCA) requires foreign financial institutions and entities to report information on accounts held by a U.S. taxpayer. In compliance with this law, foreign institutions send information including your name, address, account numbers, balances, and identification numbers to the IRS. In most cases, foreign banks will ask you to fill out Form W-8 or Form W-9 if you are a US citizen or if you ever lived in the US. Even if you do not comply with this request for information, a bank may still forward your bank account details or interest on foreign holdings to the IRS if they have reason to believe that you are a US person. If you don’t disclose your offshore accounts, you may be caught up in an IRS audit and your foreign accounts could be frozen. The IRS may also impose penalties for failure to comply with offshore account disclosures. Taxpayers who did not file an FBAR but were required to may be subject to civil and criminal penalties unless there is a reasonable cause.

Minimize Your Tax Audit Risks

If you fill out your tax return accurately and honestly, you are not likely to be audited. Full disclosure is the key. Responsible financial reporting to the IRS minimizes your risk of an audit as long as you claim legitimate deductions and tax credits. Again, maintaining proper records and paperwork cannot be overstated. Keeping track of your financial documents may help you prove eligibility for deductions and credits claimed.

In Need of a Tax Attorney?

Dallo Law Group specializes in tax audits in San Diego. An IRS audit requires the taxpayer to submit proof for the income, deductions, and credits taken on a tax return. This can be stressful, complicated, and daunting but having skilled tax attorneys who deal and negotiate with the IRS on a daily basis will give you peace of mind. There is no reason for a taxpayer to handle an IRS audit alone and Dallo Law Group offers skilled, experienced tax attorneys in San Diego who are well trained in the IRS audit process. Contact Dallo Law Group today

Written by Jamie LeBeau, Dallo Law Group