At Paragon Accountants, we are frequently asked how to avoid an IRS audit. While no one can guarantee they won’t be audited by the IRS, it’s a valid concern as tax audits can be quite stressful.
In this post, we’ll review the types of IRS notices, IRS audit red flags, how to reduce your chances of having your taxes audited by the IRS, and how to prepare in case you receive an IRS notice.
Types of IRS Audits and Notices
Correspondence or Mail-in Audit
Correspondence audits, also known as mail-in audits, are the most common type of IRS audit and are also the lowest-level tax audit. As of 2020, over 70% of all tax audits are correspondence audits. If you receive one of these, you should not worry; most mail-in audits involve small amounts of money. Correspondence audits occur when the IRS has a question regarding something you’ve reported on your individual or business tax return, and they need supporting documentation to verify that the item is in fact a legitimate deduction.
If you receive a correspondence audit, respond promptly to avoid the IRS escalating your case to an in-person audit.
Office audits take place at the IRS’s offices—not your office—to ensure that you are filing your taxes correctly. IRS agents interview individuals in-person and cover issues laid out in a written notice sent ahead of time via post mail.
Field audits are quite serious. If you receive notice that you’ll be field audited by the IRS, book an appointment with a tax accountant right away to ensure you have proper help navigating the audit process.
Field audits occur when the IRS is concerned with debits or credits you’re reporting on your tax return. These can be business, individual, or lifestyle audits. During a field audit, the IRS will dig deep and request a lot of documentation. As long as you provide the requested documents in a timely fashion, you shouldn’t worry. After you go through a field audit once, you’ll learn a lot and understand the importance of good record keeping for years to come.
A CP 2000 notice is not technically an audit, but is a letter from the IRS regarding an income discrepancy. This is the most common type of notice sent by the IRS. Receiving a CP 2000 means that what you have on your tax return doesn’t jive with what a third-party individual or business is reporting against your Social Security Number or EIN. If you receive a CP 2000 notice, don’t worry. Just respond in a timely fashion with the supporting documentation, and the item should be closed.
When Does the IRS Audit?
So what triggers an IRS audit? Tax audits are more about statistics. Since most of us have mandated e-filing for business and individual tax returns, the IRS collects data on these returns to determine statistical norms among U.S. taxpayers. If you fall outside the norms, your odds of an IRS audit increase.
But why does the IRS audit? What aspects of our tax returns trigger the IRS to dig deeper into our income, lifestyle, and spending?
We review our individual and business clients’ historical tax returns to see if the flow of revenue, expenses, and deductions are in line with what they’ve reported in the past. This doesn’t mean that you can’t earn more revenue or have additional deductions; we simply need to be prepared to defend any outliers.
Now that you are familiar with the types of tax audits and how audits arise, we’ll cover some strategies to avoid an IRS audit.
How to Avoid a Tax Audit: 4 Tips
1. File your taxes!
The best way to avoid being an IRS audit is to file your taxes each year and to do so on time. It’s that simple. You don’t owe taxes this year? That’s okay. File a return anyway.
2. Good record keeping
If you are running a small business and can’t afford a bookkeeper, keep detailed records on your own. We recommend saving records for five to ten years because the IRS can come back years after taxes were filed to make sure you have detailed records.
Individuals need to have an explanation regarding deductions and credits stated on your individual tax return.
3. Honesty is the best policy
Keep records for your business expenses and don’t stretch the truth by claiming too many expensive dinners or other high ticket miscellaneous activities.
4. Review your deductions
If you are starting to question some of the deductions or credits on your tax return, it may be time for you to hire a professional. A qualified tax accountant will make the tax filing process easier so that you feel confident that what you’re filing on your tax return was properly reviewed.
How Do I Know if I am Being Audited by the IRS?
If the IRS selects you for a tax audit, they will mail a notification to the address they have on file for you. In most cases, this will be a Notice of Audit letter which contains a response deadline, the tax return in question, and the documentation they expect you to produce.
Please note that the IRS does not contact people via phone or email.
What is the Chance of Being IRS Audited?
Luckily, for most of us the odds of being IRS audited is quite low. Your chances increase the more money you make (or if you report $0 adjusted gross income in a tax year). As of 2020, individuals who reported between $25,000 and $200,000 adjusted gross income had a 0.4% chance of being audited. Those who reported an adjusted gross income between $5 million and $10 million had a 5.1% chance of being audited.
6 Top IRS Audit Red Flags
Though we’ve already discussed best practices to avoid an IRS audit, what about audit triggers? Here are the some of the most common tax audit red flags:
1. Out-sized charitable donations
Think of it like this: If I have a client coming in who’s reporting $100,000 in income for the year and is deducting $75,000 as charitable donations, guess what? That person is most likely going to be audited by the IRS. The reason being that the proportionate revenue deduction doesn’t make sense. This doesn’t mean that you can’t take the $75,000 charitable donation, we just need to have a defense and supporting documentation in case you are audited.
2. Claiming business losses
Claiming business losses is another common IRS audit trigger. With the 2020 economy behind us, the IRS is experiencing a lot more reported business losses, but that doesn’t mean that they have ceased auditing for this reason. If you experience business losses due to the current environment, or if you continually generate losses, you are more likely to be audited.
3. Hobby businesses
If you are earning income from a side hustle, the IRS needs to determine whether your endeavor is a hobby or a business. Put simply, businesses exist to profit and hobbies are intended as recreational.
Hobby businesses have restrictions on the losses that can be deducted against your ordinary income, which is why you need to meet with a tax accountant to ensure you understand whether or not your endeavor is a bonafide business or is actually a hobby.
4. Home business offices
Home office deductions are a very common tax deduction for businesses operating out of a home. While the IRS allows home office deductions, there are specific rules regarding how you take that deduction. Many of our new clients come to us with a home office deduction that is a little too aggressive. This can trigger an IRS audit. If you are deducting a home office, it needs to be an actual office and solely used for work.
5. Not reporting all of your income
As we discussed above, not reporting all of your taxable income is a great way to receive a notice from the IRS. Be sure to report your income accurately!
6. Taking credits, losses, or deductions that are higher than tax payer norms
If your deductions, credits, or losses are unusually high, be sure you have appropriate documentation for these items. This is a red flag for the IRS, so you’ll need to be prepared.
For more information on IRS audit red flags, see our post on the top 10 tax audit triggers.
Watch our video on how to avoid an IRS audit:
With these tips, you are better equipped to adequately prepare your taxes. As long as you have a tax professional on your side helping to guide you through the process, you shouldn’t worry about being audited. Just be sure to respond promptly if the IRS contacts you.