Top IRS Audit Red Flags

Every taxpayer dreads when they receive an envelope with those three bold letters on it; IRS. The situation gets worse when you find out that you’ve been selected for “examination” as the service likes to term it (i.e. audit). Have you ever wondered why some tax returns are selected for further review while most are ignored? For example, in 2013 (FY 2014 is the most recently available data) there were 145.2 million individual tax returns filed, of which 1.2 million were selected for review in 2014. Thus the effective audit rate was 0.86%. So the odds are pretty low that your return will be picked for review. However, those odds may change depending on if IRS computers detect any of the following “red flags” when your return passes their always watchful eyes.

Failing to Report All Taxable Income
All those 1099s and W-2s you receive; well the IRS gets copies of them as well. The IRS computers are pretty good at matching the numbers on the forms with the income shown on your return. A mismatch (e.g. too little or too much being reported) sends up a red flag. If it’s a computational error, the IRS will usually fix it and send you a letter with the changes and additional tax owed. If it’s a reporting error (meaning it was reported under your SSN but it didn’t belong to you), then you will want to contact the IRS/issuer so that it can be corrected.

Running a Small Business
Those who operate their small business as a “sole-proprietor” will report their activity on Schedule C. This form tends to be a treasure trove of tax deductions for sole-proprietors and a gold mine for IRS agents. Why? Well those at the service know that those filing the form sometimes claim excessive deductions or don’t report all of their income. Special scrutiny is typically given to cash-intensive businesses (taxis, car washes, bars, hair salons, barbers, etc.) and those who report substantial losses. Also, the audit rates increase depending on how much they earn. According to the FY2014 statistics, those businesses with gross receipts of $25,000 or less were audited at a rate of 1.01% while those with receipts between $100,000 and $200,000 saw that rate raises to 2.43%.

Claiming the Home Office Deduction
The IRS is drawn to returns that claim home office write-offs because it has historically been successful in reducing the deduction. Why? Well, if you have an office in your home, it has to be used “exclusively” for business in order to be claimed on the return. So if you have a 2nd bedroom that is used as the office, chances are you’ll survive the review. If it’s a family room or den? Good luck convincing the agent that its use is exclusive. However, if you do qualify for the deduction, know that you can deduct a percentage of your mortgage interest/rent, real estate taxes, utilities, phone bills, insurance and other costs.

Claiming the Earned Income Credit (EITC)
The Earned Income Credit (EITC or EIC) is a refundable tax credit for low-to moderate-income working individuals and couples; particularly those with children. The amount of EITC benefit depends on a recipient’s income and number of children. However, the EIC is also a great source of fraud. Why? Well, tax preparers and certain individuals know that there is a “sweet spot” in calculating the credit. If you get the income and dependents just right, you can receive a much larger credit that you are entitled to. Unfortunately, the IRS knows this but has been little combat the fraud. “The IRS estimates that 22 to 26 percent of EITC payments were issued improperly in Fiscal Year 2013. The dollar value of these improper payments was estimated to be between $13.3 billion and $15.6 billion.” So above we said that businesses with gross receipts of $25,000 or less were audited at a rate of 1.01%. Well that rate was 1.78% if the EIC was involved as manipulating the “earned income” on the Schedule C can change the EIC amount.

Being a High Wage Earner
The 0.86% audit rate translates into about one in every 116 returns being selected for review. For people with incomes of $200,000 or higher the audit rates changes to 1.75%, or one in every 57 returns. Report $1 million or more of income? There’s a one-in-16 chance your return will be audited. Make less than $100,000? Only 0.52% of such returns were audited during 2014 or one out of every 192.

Claiming Rental Losses
If you actively participate in the renting of your property, you can deduct up to $25,000 of loss against your other income. A second exception applies to real estate professionals who spend more than 50% of their working hours and 750 or more hours each year materially participating in real estate as developers, brokers, landlords or the like. The problem is 1) some taxpayers claim the $25,000 deduction when they shouldn’t (i.e. multiunit dwellings in which they occupy a unit) and 2) they fail to satisfy the test of being a real estate professional. Thus, those with rental losses are prime candidates for the IRS to take a second look at.

Taking Higher-than-Average Deductions
If deductions on your return are disproportionately large compared with your income or profession, the IRS may pull your return for review. For example, if you are self-employed as an attorney and 35% of your gross receipts on Schedule C are spent on meals and entertainment, the computer may flag the return when the national average is only 10%. But when it’s discovered that you are an entertainment attorney in Los Angeles, all might be okay. In any instance, if you have the proper documentation for your deduction you shouldn’t be afraid to claim it.

Taking Large Charitable Deductions
Charitable contributions are a great write-off and help you feel all “do goodie” inside. But if your deductions are disproportionately large compared with your income, it raises a red flag. This is because the IRS knows what the average charitable donation is for folks at your level. Also, if you don’t get an appraisal for certain donations or fail to file Form 8283 for noncash donations over $500, you become an even bigger target.  With that said, be sure to keep all your supporting documents and follow these tips in case the IRS wants you to prove the number listed on your return.

Improper Reporting of Capital Gain/Loss Transactions
When you sale or dispose of a house, stocks, options, etc. the transaction will typically be reported to the IRS via Form 1099-S, 1099-A, 1099-B, etc. Well, if you don’t report the cost and selling prices correctly or in line with what the IRS has, then they will sometimes send you a letter. Not all of these items will result in more tax for you as the IRS amounts may not reflect the entire story. For example, if you sell stock for $10,000 but the cost/basis is shown as $0, the IRS will expect to see you report a $10,000 gain. But what if the cost/basis isn’t correct and you really paid $12,000 for the stock (which wasn’t reported to the IRS)? Well, your $10,000 gain is really a $2,000 loss and simply has to be proven/explained to them.