- Discover some red flags that could trigger an audit by the IRS.
- Find out how disparities between information on tax forms and reported income can raise eyebrows.
- Watch out for disparities between business income and business expenses.
- Find out how your charitable contributions could wave a red flag to the IRS.
- Learn how a modest income paired with deductions reflecting a high-income lifestyle could make the IRS pay attention.
- What happens when you hit the perfect income-to-expense ratio to qualify for the Earned Income Credit?
- Discover how disproportionate itemized deductions may trigger an audit.
- If you haven’t been reporting your gains or losses on cryptocurrency, you may have a problem.
- What happens if your rental property expenses appear inflated?
- Two people claiming the same dependent may catch the attention of the IRS.
- Learn how using the wrong filing status can raise red flags.
- Find out how failing to report overseas accounts could raise an alarm.
Tax time can be one of the most hated times of the year. Just preparing the forms is enough to be an irritant, and if you owe the government money, there’s a good chance that you’re downright annoyed. But neither of those things compare to the feeling that accompanies an envelope bearing an IRS return address. This envelope alerts you to the fact that your taxes are about to experience an audit.
How many people experience an audit?
Audits are relatively rare in the United States, but we know that people fear them. However, the IRS reports that between 2010 and 2018 only 0.6% of individual tax returns resulted in an audit. That may make you feel better, but statistically that still means that more than 250,000 taxpayers experienced an audit. In many cases the audit process could have been avoided had the taxpayers simply known what we’re about to spell out for you – that there are specific triggers that send up IRS red flags and frequently lead to an audit process. Fiducial has a list of the top red flags that may trigger an audit.
Red flags for audits
Disparities Between Information on Tax Forms and Reported Income
Whether you’re a W-2 employee or self-employed, the IRS will compare the income information that you report on your tax forms with the W-2 and 1099 forms that are sent by those individuals and entities that have paid you. If the two don’t match, the IRS is going to want to know why.
Disparities between business income and business expenses may cause an audit
Just as the IRS will respond when your tax form income and reported income don’t match, the same is true for businesses that report business expenses that don’t make sense. In some cases, the IRS looks for people trying to take business expense deductions for a hobby, not a business. Many times these disparities occur for actual expenses incurred for which income went unreported. The chance exists that the odd numbers occurred by accident, such as the duplication of employee and business expenses. That oversight can lead to the discomfort of an audit. So, take the time to double and triple check before filing your tax forms.
Out-sized charitable contributions
Our tax system awards charitable contributions with tax deductions. Though that has proven to be a powerful incentive for some, it has also served as a temptation. To counter this, the IRS has created an automated computer program that analyzes nearly every return to identify figures that seem out-sized as compared to an individual’s income, as well as other factors that are commonly abused. The system assesses each return based on numerous factors and assigns a DIF, or Discriminate Function, score. If your return exceeds the IRS DIF score threshold, there’s a good chance you’re headed for an audit.
Disparities between lifestyle expenses and reported income
Like other tax return mismatches, the IRS flags the returns of taxpayers taking deductions for expenses reflecting high income living but reporting a more modest income. Paying personal property taxes, real estate taxes and taking mortgage interest deductions for million-dollar lifestyles will raise a red flag if the income you’re reporting is not enough to support it.
When you hit right on the income-to-expense ratio needed to qualify for the EIC
To claim the Earned Income Credit — which can be as high as $6,660 for tax year 2020 — taxpayers’ income has to be below a certain level, and if you’re a business owner whose return includes a Schedule C to prove all offsetting expenses, there is a particular ratio that you need to achieve in order to qualify. In most cases a business will either be somewhere below the ratio or above the ratio: They’ll either qualify for a larger Earned Income Credit or they won’t. If the number hits exactly at the level needed for the larger credit, the IRS will take a closer look. They want to see if numbers on either side of the equation have been manipulated.
Disproportionate itemized deductions may trigger an audit
If you qualify to itemize, then you’re entitled to take deductions for qualifying expenses. But in cases where itemized deductions seem disproportionately high, the IRS is likely to ask some questions. If the expenses are legitimate and you’re able to present documentation, you’ll be fine, but make sure that you hold onto all receipts, as there’s a good chance that you’ll be called in for an audit.
One important thing to remember: While you may have deducted unreimbursed employee business expenses in the past, that stopped being true for federal income taxes after tax year 2017. Some states, including California, still permit those deductions on state taxes. So, make sure that you maintain receipts for those returns as well.
Lapses in reporting cryptocurrency transactions
Bitcoin and other virtual currency transactions have led to plenty of tax return headaches. For instance, in the last several years approximately 10,000 taxpayers have failed to report gains or losses on this currency. To address the issue, the IRS sends taxpayers letters providing a chance to take part in a voluntary disclosure program.
The agency is clearly on the watch for and acting upon this particular red flag. In addition, the IRS has added a question to the 1040: “Did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” Of course, if you answer no and later it is determined you did, then you have committed perjury since you sign your return under penalty of perjury.
Rental property expenses that appear to be inflated may cause an audit
One of the most common reasons for the flagging of tax returns involves rental expenses that appear inflated. Taxpayers who prepare their own returns and who report deductions for rental income on their Schedule E need to ensure that they fully understand that they may claim some deductions but they must capitalize some over time. Not knowing which is which could lead to a flagged return. There are also special and rather complicated rules associated with renting a vacation home, room rentals and short-term rentals.
Two people claiming the same dependent
Often, families that split custody of a dependent as a result of separation or divorce alternate the years in which they claim a dependent. However, if the IRS detects mistakes – or fraud – and both claim the same individual, that will surely trigger an audit. Proving custody will require documentation, including school records and birth certificates.
Not understanding which filing status to use
Though you may find the head of household filing status extremely useful, some can find it confusing. It can also lead to mistakes when filling out status, especially regarding the treatment of dependents. Though the Tax Cuts and Jobs Act of 2017 was supposed to simplify the tax form process, in this particular area it made things even more complicated by introducing a new $500 credit for ‘qualifying relatives’, which is defined by certain tests that may make people not related to the taxpayer eligible as a dependent while not making the taxpayer eligible for the head of household filing status.
Failure to report overseas accounts
Whether it generates taxable income or not, U.S. citizens or U.S. residents with interest in, authority over, or signature authority on foreign financial accounts that exceed $10,000 at any time during the calendar year, must report them to the U.S. Treasury Department under the Bank Secrecy Act. You must use the appropriate form, the Report of Foreign Bank and Financial Accounts, or FBAR. Failing to disclose these accounts can have significant repercussions. Disclosure requirements placed on foreign financial institutions will likely make your accounts easily discoverable.
In case of audit
We provide this information to fend off the possibility of ever having red flags raised on your tax filing. However, if one of those envelopes with the IRS return address appears in your mailbox, contact Fiducial immediately. Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.
For more small business COVID-19 resources, visit Fiducial’s Coronavirus Update Center to find information on SBA loans, tax updates, the Paycheck Protection Program, paid sick and family leave, and more.