Let’s face it, none of us ever want to hear the words “IRS audit”. The good news is that the odds of being audited by the IRS are at the lowest levels in at least a decade. In fact, the probability of being audited for a median household income in the US dropped to less than 1% in 2014 versus 5.6% in 1993.
The IRS still audits approximately 1.1 million taxpayers every year, and these numbers are projected to remain at similar levels next year.
The decline of IRS resources and increases in scrutiny is due to the IRS’s audit process. The IRS has been forced to be more efficient. Automation with computer document matching programs and the use of sophisticated algorithms has allowed the IRS to select returns that fall outside of statistical norms for review within minutes. Understanding what the IRS deems as “statistically normal” and staying within these ranges will decrease your chances of an audit.
Sounds simple, right? Unfortunately, understanding the Internal Revenue Code isn’t. Don’t worry, Paragon is here to help.
Here are 10 of the most common red flags that oftentimes “trigger” an audit:
1. Not reporting all taxable income – IRS document matching programs can determine any discrepancy between what you report on your return versus what has been reported against your social security number via third party entities. Most common of these:
- 1099 – Securities, Gambling Winning, Independent consulting income, retirees RMD
- Foreign bank account – recent hot trigger
If you file your own taxes, reference your prior year return to determine if you are missing any tax documents. If you file your taxes with a tax professional, ask them for a tax planner checklist. You’ll be better prepared and more confident about filing your taxes.
2. Data entry errors – Simple errors, like transposing your dependents social security number or misspelling your name can trigger an audit. Filing returns electronically can minimize these errors. E-filing programs have the ability to verify taxpayer’s information with the IRS database before the return is even accepted. The IRS reported that the error rate on paper returns was 20% higher than returns filed electronically.
3. Household income – Those who fall in the less than 1% audit probability report a household income ranging from $25K – $199K a year. If you are fortunate enough to report higher than median income levels, your probabilities of an audit increase to 4% at household income levels that range from $200K – $1M.
Audit probabilities continue to increase as you go further up the income scale. On the opposite end, taxpayers with no adjusted gross income experience increase audit probabilities as well — up to 5%.
What is the reason for this income relationship and their respective probabilities of being audited? Low income reporters typically qualify for tax credits that have historically been abused or have been fraudulently used in aggressive tax planning strategies. High income earners are increasingly targeted as well because their individual returns have more complexity and room for misinterpretation. In addition, higher income taxpayers are more likely to have the financial resources that can be used to employ or enlist the help of financial experts that will do all that is in their power to minimize their tax liability. Sometimes, this can lead to tax evasion.
4. Higher than average deductions – As mentioned earlier, the IRS has the ability to compare your itemized deduction with others in your tax bracket. Their computer software and complex algorithms can detect the reasonableness of the deductions taken on your return to determine if an audit is necessary. The most common deduction triggers are:
- Charitable Donations: If your donations are disproportionate compared to your income, it raises a huge red flag. That doesn’t mean you can’t claim your donations, but you must keep accurate records and report all non-cash donations over $500 on the proper tax form and get an appraisal for any donation of property worth more than $5,000.
- Business use of home, auto, travel, entertainment, casualty losses and bad debt: Either reported on a Schedule C by business owner, or on a Schedule A by an employee — are all audit triggers when these deductions are disproportionately high for your business or profession.
5. Self-employed – Many taxpayers file Schedule C for their sole proprietor business activity. Failing to report a profit in at least 3 out of the 5 years increases your risk of further scrutiny. The IRS flags businesses with excessive losses and may deem the activity as a hobby and disallow the deductions.
6. Rental losses – Normally the passive loss rule prevents the deduction of rental real estate losses, but there are some exceptions. The IRS actively reviews taxpayers (claiming to be real estate professional) when they have substantial W2 income from an employer outside of the real estate industry. Excessive real estate losses also get audited for “market value rents” to determine if taxpayer is intentionally incurring losses.
7. Failure to properly pay household help – You might be familiar with what some call the “Nanny Tax”. This can cause an audit if you find yourself in a wage dispute. A typical scenario is a household worker who gets hurt in your home, and files for workers’ comp, or tries to collect unemployment. If you have household help, such as childcare, housekeepers, or an aid to help care for an elderly member of your family, you might be susceptible to an IRS audit. If any of these individuals earns $1,900 (or more) in a given year, you must have taxes withheld from their pay. Many taxpayers believe that reporting these payments on a 1099 will eliminate this payroll requirement, but in most cases it will not.
8. Discrepancy between individual taxpayers and corporation filling associated to taxpayer – The IRS may compare the tax return of the shareholders of a corporation to the corporation tax filing and filings that don’t report consistency will increase your chances of an audit.
9. Hiring a reputable tax preparer – Unfortunately, there are some unethical tax professionals out there. Get references, review professional designations, and confirm that your tax professional maintains a current tax identification number with the IRS. This is mandatory.
If the IRS has flagged your tax professional for seemingly aggressive tax planning, there’s a high likelihood that you will be guilty by association, and audited as a result. If a tax professional promises you large refunds, without asking to see proper documentation for deductions and credits, you’ll be on the hook to defend these items in an audit. A good rule of thumb is: if it seems too good to be true, it probably is.
10. Does a tax extension increase/decrease your chances of an audit? – The most common — albeit misguided — belief is that filing an extension will decrease your chances of getting audited. Many believe that the IRS has audit quotas that need to be met before the extension deadline. However, this line of thinking has yet to be validated. What we know is that filing for an extension is oftentimes necessary for more time that will, in most cases, lead to a more accurate return. Filing an extension should allow you to gather all the necessary tax documentation, and accurately file your taxes, which should decrease your chances of an audit.
In the unfortunate case you do get audited, respond to your IRS letter promptly. Most of the time, the IRS is simply asking for some form of documentation. If you don’t understand the request sent to you from the IRS, or you’ve been called in to meet with an agent, you should almost certainty seek professional help.
Audits are an integral part of the tax collection process, and will remain as such for a long time to come. The key to avoiding an audit is to be honest, document your donations, your deductions, and report all of your income.
As always, Paragon is here to assist you with any questions you have regarding audits and the tax filing process.