The IRS audits
only about 1% of all individual tax returns annually. The agency doesn’t
have enough personnel and resources to examine each and every tax
return filed during a year. So the odds are pretty low that your return
will be selected for an audit. And of course, the only reason filers
should worry about an audit is if they are cheating on their taxes.
However, the
chances of you being audited or otherwise hearing from the IRS can
increase depending upon various factors, including whether you omitted
income, the types of deductions or losses claimed, certain credits
taken, foreign asset holdings and math errors,
just to name a few.
Although there’s no sure way to avoid an IRS audit, you should be aware
of red flags that could increase your chance of drawing some unwanted
attention from the IRS.
Here are the 12 most important ones:
1. Failure to report all taxable income.
The IRS
receives copies of all 1099s and W-2s that you receive during a year, so
make sure that you report all required income on your tax return. The
IRS computers are pretty good at matching these forms received with the
income shown on your return. A mismatch sends up a red flag and causes
IRS computers to spit out a bill. If you receive a 1099 for income that
isn’t yours or the income listed is incorrect, get the issuer to file a
corrected form with the IRS.
2. Returns claiming the home-buyer credit.
First-time
homebuyers and longtime homeowners who claimed the homebuyer credit
should be prepared for IRS scrutiny. Make sure you submit proper
documentation when taking this credit. First-time homebuyers have to
attach a copy of their settlement statement to the return, and longtime
homeowners should also attach documents showing prior ownership of a
home, including records of property tax and insurance coverage. All
claims for this credit are being screened. As of May 2010, more than
260,000 returns had been selected for correspondence audits
(examinations done by mail rather than face-to-face) because filers did
not attach the necessary documents to their tax returns. And those
numbers will continue to grow.
Also, the IRS
has ways of policing the recapture of the homebuyer credit. Generally,
the credit is required to be recaptured if the home is sold within three
years for homes brought in 2009 or 2010 and within 15 years for homes
bought before 2009. The IRS is checking public real estate databases for
sales of homes for which the credit was taken.
3. Claiming large charitable deductions.
This comes up
again and again because the IRS has found abuse on audit, especially
with those taking larger deductions. We all know that charitable
contributions are a great write-off and help you to feel all warm and
fuzzy inside. However, if your charitable deductions are
disproportionately large compared to your income, it raises a red flag.
That’s because the IRS can tell what the average charitable donation is
for a person in your tax bracket. Also, if you don’t get an appraisal
for donations of valuable property or if you fail to file Form 8283 for
donations over $500, the chances of audit increase. Be sure you keep all
your supporting documents, including receipts for cash and property
contributions made during the year, and abide by the documentation
rules. And attach Form 8283 if required.
4. Home office deduction.
The IRS is
always very interested in this deduction, primarily because it has a
pretty high adjustment rate on audit. This is because history has shown
that many people who claim a home office don’t meet all the requirements
for properly taking the deduction and others may overstate the benefit.
If you qualify, you can deduct a percentage of your rent, real estate
taxes, utilities, phone bills, insurance, and other costs that are
properly allocated to the home office. That’s a great deal. However, in
order to take this write-off, the space must be used exclusively and on a
regular basis as your principal place of business. That makes it
difficult to claim a guest bedroom or children’s playroom as a home
office, even if you also use the space to conduct your work. Exclusive
use means a specific area of the home is used only for trade or
business, not also where the family watches TV at night. Don’t be afraid
to take the home-office deduction if you’re otherwise entitled to it.
Risk of audit should not keep you from taking legitimate deductions. If
you have it and can prove it, then use it.
5. Business meals, travel and entertainment.
Schedule C is a
treasure trove of tax deductions for self-employed. But it’s also a
gold mine for IRS agents, who know from past experience that
self-employed taxpayers tend to claim excessive deductions. Most
under-reporting of income and overstating of deductions are done by
those who are self-employed. And the IRS looks at both higher-grossing
sole proprietorships as well as smaller ones.
Big deductions
for meals, travel and entertainment are always ripe for audit. A large
write-off here will set off alarm bells, especially if the amount seems
too large for the business. Agents know that many filers slip in
personal meals here or fail to satisfy the strict substantiation rules
for these expenses. To qualify for meals or entertainment deductions,
you must keep detailed records generally documenting the following for
each expense: amount, place, persons attending, business purpose and
nature of discussion or meeting. Also, receipts are required for
expenditures over $75 or any expense for lodging while traveling away
from home. Without proper documentation, your deduction is toast.
6. Claiming 100% business use of vehicle.
Another area
that is ripe for IRS review is use of a business vehicle. When you
depreciate a car, you have to list on Form 4562 what percentage of its
use during the year was for business. Claiming 100% business use for an
automobile on Schedule C is red meat for IRS agents. They know that it’s
extremely rare that an individual actually uses a vehicle 100% of the
time for business, especially if no other vehicle is available for
personal use. IRS agents are trained to focus on this issue and will
closely scrutinize your records. Make sure you keep very detailed
mileage logs and precise calendar entries for the purpose of every road
trip. Sloppy recordkeeping makes it easy for the revenue agent to
disallow your deduction. As a reminder, even if you use the IRS’
standard mileage rate to deduct your business vehicle costs, ensure that
you are not also claiming actual expenses for maintenance, insurance
and other out-of-pocket costs. The IRS has found filer noncompliance in
this area as well and will look for this.
7. Claiming a loss for a hobby activity.
Your chances of
‘winning’ the audit lottery increase if you have wage income and file a
Schedule C with large losses. And, if your Schedule C loss-generating
activity sounds like a hobby, i.e., horse breeding, car racing, and
such, the IRS pays even more attention. It’s issued guidelines to its
agents on how to sniff out those who improperly deduct hobby losses.
Large Schedule C losses are audit bait, but reporting losses from
activities in which it looks like you might be having a good time is
just asking for IRS scrutiny.
Tax laws don’t
allow you to deduct hobby losses on Schedule C; however, you do have to
report any income earned from your hobbies. In order to claim a hobby
loss, your activity must be entered into and conducted with the
reasonable expectation of making a profit. If your activity generates
profit three out of every five years (or two out of seven years for
horse breeding), the law presumes you’re in business to make a profit,
unless the IRS establishes to the contrary. If audited, the IRS is going
to make you prove you have a legitimate business and not a hobby. So,
make sure you run your activity in a business-like manner and can
provide supporting documents for all expenses.
8. Cash businesses.
Small business
owners, especially those in cash-intensive businesses, i.e., taxi
drivers, car washes, bars, hair salons, restaurants and the like, are an
easy target for IRS auditors. The agency is well aware that those who
primarily receive cash in their business are less likely to accurately
report all of their taxable income. The IRS wants to narrow the tax gap,
and history has shown that cash-based businesses are a good source of
audit adjustments. It has a new guide for agents to use when auditing
cash intensive businesses, telling how to interview owners and noting
various indicators of unreported income.
9. Failure to report a foreign bank account.
The IRS is
intensely interested in people with offshore accounts, especially those
in tax havens. U.S. tax authorities have had some recent success in
trying to get foreign banks (such as UBS in Switzerland) to disclose
information on U.S. account holders. Also, the IRS had a voluntary
compliance program where people came in and reported their foreign bank
accounts and foreign assets in exchange for lesser penalties than they
would have otherwise been subject to. The IRS has learned a lot from
these probes.
Failure to
report a foreign bank account can lead to severe penalties, and the IRS
has made this issue a top priority. Make sure that if you have any such
accounts, you properly report them when you file your return. Keep in
mind, though, that if you have never previously reported the foreign
bank account on your return, and you decide to do so for the first time
in 2010, that might also look suspicious to the IRS.
10. Engaging in currency transactions.
The IRS gets
many reports of cash transactions in excess of $10,000 involving banks,
casinos, car dealers and other businesses, plus suspicious activity
reports from banks and disclosures of foreign accounts. A recent report
by Treasury inspectors concluded that these currency transaction reports
are a valuable source of audit leads for sniffing out unreported
income. The IRS agrees and it will make greater use of these forms in
its audit process. So if you are a person who makes large cash purchases
or deposits, be prepared for IRS scrutiny. Also, beware that banks and
other institutions file reports on suspicious activities that appear to
avoid the currency transaction rules (such as persons depositing $9,500
cash one day and an additional $9,500 cash two days later).
11. Math errors.
One of the
biggest reasons that people receive a letter from the IRS is because of
mathematical mistakes they make on their tax returns. If you make an
error in your favor, you are going to hear from the tax man, and there
is a greater risk of the IRS pulling the whole return for audit. So take
time to ensure all your calculations are correct. Even though math
errors may not lead to a full-blown audit, it’s always best to remain
under the radar of IRS computers.
12. Taking higher-than-average deductions.
If deductions
on your return are disproportionately large compared to your income, the
IRS audit formulas take this into account when selecting returns for
examination. Screeners then pull the most questionable returns for
review. But if you’ve got the proper documentation for your deduction,
don’t be afraid to claim it. There’s no reason to ever pay the IRS more
tax than you actually owe.
