The possibility of being audited by the IRS can induce fear and panic in even the most honest taxpayers. While getting flagged for an audit does not automatically mean you’re in trouble, it’s still an inconvenient and stressful process you’ll want to avoid if possible. The best way to steer clear of extra scrutiny is to understand what may trigger an audit in the first place.
Knowing the most common audit red flags can help you proactively minimize your risks when filing your tax return. With some awareness and preparation, you can reduce the chances of hearing from the IRS and breathe easier as tax season approaches.
Understanding the Audit Process
An IRS audit is a review and examination of your tax return to verify that everything is reported correctly according to tax laws. If selected for an audit, you will have to provide documentation that supports the information on your return.
Audits can take place in person at an IRS office, through the mail, or online, depending on the complexity of your case. The IRS typically selects returns for examination through computer scoring that looks for discrepancies or incomes that seem out of line based on your occupation or assets. When the IRS audits you, it’s important to be familiar with how they select specific returns for inspection and remain prepared. If you’re ever unsure about the audit process or your rights, consider consulting with professionals who offer specialized audit defense services.
1. High Income
Higher-income earners have a greater chance of being audited since there is more room for error in complicated returns. As income rises, taxpayers tend to have more complex returns involving business expenses, investments, rental properties, and itemized deductions. With more moving parts, the risk of mistakes, omissions, and questionable deductions also increases. High-income earners are also under greater scrutiny for hiding income or underreporting it.
2. Large Charitable Donations
While giving to charity is an admirable thing, large donations can raise red flags if they seem disproportionate to your income. This is especially true if you fail to provide proper documentation and acknowledgment from the organization.
The IRS allows up to 60% of your adjusted gross income to be deducted for donations. However, giving such a high percentage of your income will lead the IRS to verify that the organizations you donated to are legitimate and that you did not overvalue non-cash contributions. Maintaining receipts, canceled checks, and appraisals proves that your contributions are genuine.
3. Home Office Deductions
Many people have shifted to working from home over the past few years. But be aware that improperly claiming a home office can increase your audit risk. To qualify for this deduction, your home office must be your principal place of business and used regularly and exclusively for work.
Having a corner of your living room where you occasionally answer emails does not meet the criteria. You also cannot deduct a home office if you already receive an office allowance from your employer. Take the time to understand the requirements and keep records of your home office expenses.
4. Frequent Business Losses
Reporting business losses year after year will raise suspicions, especially if the activity seems more like a hobby than a business endeavor. While genuine startups often operate at a loss initially, the IRS may investigate further if your business lacks sound practices and continues to lose money indefinitely.
To avoid this, demonstrate that you professionally operate your business with the intent to make a profit. Keep records that show your marketing efforts, business plans, and how you track income and expenses.
5. Foreign Income and Offshore Accounts
Due to increased globalization and foreign investment opportunities, more taxpayers have income and assets located overseas. Under U.S. tax laws, you must report all worldwide income regardless of where you reside. Failing to disclose foreign income and financial accounts can trigger harsh penalties and potential criminal prosecution. Be sure to comply with reporting requirements such as FBAR and FATCA forms to avoid trouble.
6. Rounding Off Numbers on Deductions
Claiming deductions with overly rounded numbers like $5,000 for travel expenses or $2,000 for supplies looks suspicious and gives the impression you estimated numbers rather than tracking expenditures. While innocent mistakes can happen, too many even numbers indicate potential carelessness or even fabrication.
The IRS prefers to see variances in amounts, which are more consistent with actual business activities. Take the time to tally receipts and provide as much documentation as possible to validate expense deductions.
7. Claiming 100% Business Use of a Vehicle
Many taxpayers claim 100% business use of a vehicle, hoping for the maximum deduction. However, the IRS sets a high bar for writing off a vehicle entirely for business. You would need to prove you use it exclusively for business with no personal use, which is difficult unless you have a separate family car.
Make sure you track mileage for both business and personal use to determine the appropriate percentage based on records. The IRS may compare your records with actual mileage recorded by the car’s odometer to check for consistency.
8. Earning Money in Cash
While dealing in cash is common for some businesses, there is greater potential for underreporting income, which the IRS targets. Ensure you deposit all cash received and maintain detailed records. Issuing receipts and keeping copies helps verify sales.
Many taxpayers think cash earnings can be omitted since they are harder to trace. However, the IRS may make indirect calculations of cash flow based on your lifestyle and spending patterns. Attempting to avoid taxes by not declaring cash income can lead to harsh fraud penalties.
9. Overnight Travel Expenses
Business travel is an area of frequent abuse when it comes to expense deductions. While you can write off costs for genuine business trips, you cannot deduct expenses for extravagant accommodations, lavish meals, and extended stays for personal enjoyment.
Keep detailed records and receipts that separate legitimate business expenses from personal ones. The IRS may scrutinize per diem allowances for meals as well. Take the time to understand the complex rules around travel deductions.
10. Rental Property Losses
Owning rental property can provide valuable deductions for expenses like property taxes, repairs, mortgage interest, and travel. However, passive loss rules limit deductions you can take, especially if you do not spend significant time managing the property.
The IRS scrutinizes rental losses closely to ensure you actively manage your properties. Keep detailed, well-organized records showing your time and efforts managing the property.
Conclusion
While the thought of an audit can be intimidating, being aware of the most common red flags can help you proactively minimize your risks. Take the time to understand IRS requirements, maintain proper documentation, and report all income honestly. If you have any uncertainties or questions, it doesn’t hurt to consult with a tax professional as well.
With some preparation and care taken when filing your taxes, you can reduce the likelihood of attracting IRS attention. While not every audit can be avoided, the peace of mind of knowing you fully complied with tax laws is worthwhile.