Have you ever known someone who had an income tax audit by the IRS or state taxing authority? They’ll tell you that once was enough and in most all cases, will do everything not to have that sort of problem ever again. It’s important to know how an audit is triggered and what you can do to prevent one from happening to you. Here are some of the more common audit red flags you should know.
You Make Too Much Money
Exactly how much is too much, I really can’t say. Your chances of getting audited on your income level alone is quite small – maybe only 1 in 100. But taxpayers whose income is over $200,000 have a much higher rate – roughly 3%, or 1 out of every 27 tax returns. If you’re reporting over $1 million, your chances are about 1 in 8. Simply stated, the more you make, the greater amount the IRS can collect and your chances of being audited are greater.
Dumb Math Mistakes
Perhaps the main reason that taxpayers are audited is due to sloppy tax returns with math errors. It’s almost always better to have a paid professional prepare your return with sophisticated tax software programmed to look for errors.
Don’t report your income that’s reported to the IRS by others, and you’re almost guaranteed to get caught. The most common income type not reported is self-employment income reported on Form 1099-MISC. Employers that don’t include that year-end bonus in wages and get caught, will not get the deduction, but may have to pay employment taxes on what you paid, plus penalties and interest.
You’ve got a Big Mouth
That’s right! You told your friends how you outsmarted the IRS, maybe you’ve even posted it on-line. Now, maybe a year or two later, your friend is your friend no longer and rats you out to the IRS. Maybe even your x-wife. Don’t think it can happen? Think again. Sometimes, we even get calls from individuals asking for the number of who to call to rat out their friends, so don’t think it doesn’t happen. The IRS even offers cash incentives for friends like yours. Whistleblowers could earn a reward of up to 30% of any taxes and penalties it collects from tax cheaters. Needless to say, we have no time for friends like yours.
You Didn’t File Your Taxes
That’s right – you didn’t file your taxes. You meant to file them, but somehow never got around to it. Or you owed taxes you couldn’t pay, so you just didn’t file them. You figured sooner or later, the IRS would just forget about it. Unfortunately, the IRS almost never forgets about it and has a whopping 10 years to collect. You’re always better off filing – even if you can’t pay. If you’re not sure what you owe, or even if you have to file, obtain the services of someone like us who can guide you. Once you know exactly what the IRS knows, you can decide what you want to do.
You Were Audited Once Before
If you were audited once before, chances are pretty good they can get you again. Especially if things didn’t go in your favor. Unfortunately, there’s not much you can do about it, except to be conservative and do your best to follow the tax law.
You’re Self Employed
If you’re self-employed, you will report your income and expenses on Schedule C of your individual income tax return. Self-employed individuals have been prime targets for IRS audits for some time now. As many self-employed business owners do their own accounting and do not keep the best of business records, the IRS specifically targets this type of taxpayer as an easy target for audit changes. If you haven’t done so already, you might consider incorporating your business and hiring an accountant to help review your records periodically.
Hobby Activity Losses
Let’s say you have losses related to that new side business you are developing. And let’s just say you also had losses in the prior tax year. Showing ongoing losses from an activity can indicate that the activity is not profit-motivated. That is, it can be subject to the hobby loss limitations where your losses are simply not allowed. It does not matter that you considered it a business – only that the profit motive cannot be substantiated, and therefore disallowed.
Claiming Rental Losses
Losses on rental real estate are fairly common – however being able to take those losses on your tax return may not always work for you. You can take the losses if you’re a real estate professional or if your income is low, but most investors don’t qualify. Instead, your losses get suspended and carried forward to future year where you meet the requirements or sell the property. Many do-it-yourself taxpayers fail to fully understand the requirements, sometimes rush through preparing their own tax returns and take the loss only to get caught later.
Deducting Business Travel, Meals and Entertainment
Although you may be entitled to take the deductions, if you fail to document your expenses, you can forget about getting the deduction if audited later. This is perhaps the most commonly attacked deduction by the IRS as most taxpayers fail to keep adequate records supporting these deductions. The substantiation rules are quite strict requiring you to keep detailed records of the amount paid, who was there, the business purpose and nature of each business meeting.
Right behind taking deductions for business travel, meals and entertainment, sits the automobile expense deductions. You can deduct the greater of your actual expenses or the standard mileage expense allowed for the business use of your car. Most taxpayers don’t keep accurate and complete mileage logs and that’s where it all falls apart. Sure you can take the expense, but only if you document how many miles you drove and how many trips were actually for business … and no, you don’t get to deduct your mileage back and forth to work.
Just How Charitable Are You Anyway?
Donations to charity can really help. These can be in cash or a donation of property you own. But donate more than $250 and you’re required to keep your receipts. Donate property valued at more than $5,000; you’re required to get it appraised. Be realistic and specific about what property you donate. If your donations are large compared to the income you report, chances are you’re going to get your examination letter from the IRS.
Claiming the Home Office Deduction
Claim that home office deduction and you better be prepared to support your claim. You can claim a deduction for a portion of your home you use for work, but that portion must have exclusive use for work. That is, no television, no sofa, and no treadmill … none of the comforts of home that makes use of that spare bedroom mixed-use. This is where most home office deductions fall apart. Fortunately, the IRS has somewhat relaxed the reporting requirements for expenses, but still requires that you actually use the space solely for business purposes. Before you take this deduction, better know exactly how much it saves you and if it’s worth the risk.
Creeping Up Your Tax Deductions
Perhaps the most common screw-up is that person who got away with taking the deduction last year and tries to creep-up the deduction just a little bit more the next year thinking that they got away with it last year, so let’s just try to get away with it again this year. Just because that philosophy worked in the past, doesn’t mean it’s going to work again. Sooner or later you’re going to hit that magic number, where the IRS is going to audit your tax return, and unfortunately expand the audit to include not only the year they’re questioning, but the year before and perhaps the year before that.
Disproportionate Tax Deductions
Just when I think I’ve seen it all, I see taxpayers who take disproportionately high deductions when they report that they’ve made no money. Exactly what were they thinking when they claimed deductions more than the income they’re making. Simply stated, the less you make, the less your deductions should be. After all, what exactly did you live on? In some cases, individuals exhaust their retirement or bank accounts, and that all makes sense. But report that you’re not making any money – you better not be reporting lots of crazy tax deductions, or you’re asking for trouble. Think it doesn’t happen? We see it every day.
Reporting Foreign bank accounts
Do you still keep your money in your foreign bank account? In the good old days, the big earners could shelter money off-shore and sometimes get away with it. Not so much anymore. Now, the IRS has entered into agreements with foreign banks and countries to share information about what assets you have there. Fail to report your foreign bank accounts and you could be paying, not only the taxes, but penalties of $10,000 or more. In addition to reporting foreign bank accounts, you now also have to report any foreign assets including pension funds and foreign stocks totaling $50,000 or more.
Investment Gains and Losses
In the past, broker were only required to provide the IRS with the date you sold your stocks and how much money you received. Not anymore. Your broker will now provide the same information plus the gain or loss you had on each of your stock sales. The All Cash Business – Own a restaurant, bar, taxi cab, hairdresser or liquor store or any other business that primarily collects cash and you’re a prime target for an IRS examination. Experience shows that those businesses who receive most of their revenues in cash are far more likely to omit a portion of their income from income tax reporting. Accordingly, the IRS uses other methods in determining what your real income was such as looking at cost of supplies, products sold, mileage or any other indicator that might be more likely to determine just exactly how much business you transacted.
Shopping Around for Tax Preparation Services
I can only say “You asked for it”. Shop around for the lowest tax preparation price, or worse, the biggest tax refund, and you’re just asking for trouble. Not only is the IRS looking at your return, they’re often looking at who prepared it. When choosing a tax preparer you need to consider that preparer’s professional credentials and reputation. Choose a tax preparer who pushes that envelope too far and your return might be chosen for examination simply because of who you used to prepare your taxes. Don’t think it can happen to you? Think again. Ultimately, you’re the one responsible for your tax return and not the person who helped you prepare it.
We hope you will find this article informative and help you prepare for the coming tax year. Should you receive that unexpected letter from the IRS, inquiring about your return or notifying you of an IRS examination, please contact our office for professional assistance ion representing you or your Company at a reasonable cost.