Read our free tax guide 5 Tax Hacks for Investors.
You may have read stories over the last couple of years that the IRS is conducting fewer audits due to budget cuts. But keep in mind that audits do happen, and that your last three tax returns are subject to scrutiny! To prevent fraud, the IRS continues to increase their usage of automated programs to identify tax returns that they believe warrant further scrutiny. Here are 10 IRS audit triggers to be aware of.
1. Math Errors and Typos
The IRS has programs that check the math and calculations on tax returns. If your return “doesn’t add up,” it may be flagged for further review. Double check your social security numbers – and your math.
2. High Income
Fewer than 1% of tax returns with $200,000 or less in income are audited. That percentage grows to 10% and higher for those earning above $1 million. Obviously, you don’t want to try to earn less money to avoid an audit! As you’d expect, the higher your income, the more likely you will get attention from the IRS.
3. Unreported Income
The IRS receives copies of your W-2s and 1099s, and their systems automatically compare this data to the amounts you report on your tax return. A discrepancy, such as a 1099 that isn’t reported on your return, could trigger further review. So, if you receive a 1099 that isn’t yours, or isn’t correct, don’t ignore it. Contact the issuer of that 1099 and ask them to report a corrected form to the IRS.
4. Excessive Deductions
The IRS will compare your itemized deductions to the average total deductions for a given item claimed by other taxpayers who are in the same income range as you. A taxpayer whose deductions appear to exceed these averages may be further scrutinized by the IRS. Don’t hesitate to claim every deduction that you are entitled to – just make sure you have the proper documentation.
5. Schedule C Filers
The IRS particularly watches for businesses that operate primarily with cash – and almost certainly those that are reporting a loss. They have lots of experience auditing self-employed taxpayers who underreport income or overstate expenses. Just make sure your records support what you are reporting.
6. Claiming 100% Business Use of a Vehicle
The IRS knows that it’s rare for someone to use a vehicle they own 100% of the time for business purposes. And, if you don’t have another personal vehicle registered in your name, it’s nearly impossible to report that the vehicle is exclusively used for business. Claiming 100% business use of a vehicle will almost certainly draw IRS attention. The higher percentage you are claiming, the more critical it is that you have detailed records.
7. Claiming a Loss on a Hobby
Writing off expenses for a business is fine – but you can’t portray your hobby as a business. For it to be a business, you must have a reasonable expectation to make a profit. In general, the IRS will expect you to report a profit for 3 of every 5 years you operate the business. If you report your hobby as a business, it must be run like a business, with appropriate records and documentation. Otherwise, the IRS could require you to restate any business income/loss as a hobby income/loss, subject to hobby rules. For more information, refer to the IRS’s rules on hobbies.
8. Home Office Deduction
To claim the Home Office Deduction, you must use a portion of your home “regularly and exclusively” for business. Keep in mind that the IRS doesn’t see the dining room table as a desk! And having a TV in the “home office” could raise exclusivity questions. Most importantly, home office deductions from a person earning wages may draw increased attention, so make sure home office expenses are well-documented and supported.
9. Deducting Business Meals, Travel and Entertainment
This is another area that draws IRS attention because of past abuse. First, it’s probably obvious that you can’t deduct expenses for which your employer reimburses you. Second, you must keep careful records – not just a receipt, but also a record of who was in attendance and the specific business purpose. The IRS doesn’t want you enjoying lavish meals and entertainment on Uncle Sam’s nickel.
10. Earned Income Tax Credit (EITC)
The IRS estimates that billions of dollars of EITC claims are paid in error. Some errors are unintentional, but the IRS scrutinizes EITC claims closely to prevent fraud. If you claim the Earned Income Tax Credit, make sure to document how you meet EITC rules so that you can provide this documentation to the IRS in the future, if needed.
Understanding the flags that can trigger an IRS audit is a good way to help you verify that your tax return deductions and claims are accurate and well-documented. Working with a credible CPA, however, is probably your best line of defense when it comes to IRS audits. Not only will a good CPA be able to help you file your taxes and ensure that these IRS audit triggers are all by the books, but they will also be able to provide detailed documentation and information on your behalf if you should get audited.