Three letters that NO ONE wants to hear – IRS. And a word you never want to hear right after IRS is Audit! Thankfully, the odds that your tax return will be singled out for an audit are low. The IRS audited only 0.45% of all individual tax returns in 2019. In other words, roughly 1 out of every 220 taxpayers were audited last year
Why does the IRS audit people?
The IRS attempts to minimize what they call the “tax gap.” This is the difference between what is owed vs. what is paid.
The IRS chooses to audit taxpayers based on suspicious activity. So how can you avoid an audit? Avoid these red flags.
Failing to report all income
The IRS gets copies of all the 1099s and W-2s you receive. They automatically match income to people. If you don’t account for all income, it’s an immediate red flag.
If you make mistakes, the IRS assumes you probably made more. Make sure you double and triple-check your numbers. Don’t be tempted to round. When making your calculations, be precise and avoid making estimations.
Using a quality tax preparer is key to preventing these types of mistakes.
Excessive business expenses
Running a business creates expenses. The IRS has a general rule that the expense needs to be common and accepted for the type of business and necessary and prudent for the running of your business. Are the expenses disproportionately large compared to your income?
Be careful of taking too many or too high of expenses for meals and travel. The IRS also scrutinizes writing off your automobile expenses. Make sure you keep detailed mileage logs and precise calendar entries for the purpose of every road trip. As a reminder, if you use the IRS’s standard mileage rate, you can’t also claim actual expenses for maintenance, insurance, and more.
IRS Audits when you have too many charitable donations
If you made contributions to a charity, please claim them. However, make sure you can prove every donation. This will reduce the perception of false claims.
Like business expenses, your donations will be looked at in comparison to your income. The IRS knows what the average charitable donation is for people at your income level.
Too many losses on a Schedule C (for self-employed)
Make sure your losses on a Schedule C make sense. If you are claiming losses, make sure it’s an actual business (see below about losses on a hobby).
Review the business expenses section for red flags (that could impact the losses on a schedule C).
Claiming a home office deduction
Do you use your home office “exclusively and regularly for your trade or business?” If not, you probably should not consider claiming your home office. Claiming a home office deduction may be more credible if you have set off a section of your home strictly for business purposes.
Losses for a hobby
If you have year after year of losses on a Schedule C, the IRS may see your business more as a hobby. To be eligible to deduct a loss, you must be running the activity in a business-like manner and have a reasonable expectation of making a profit.
Claiming rental losses
The IRS actively scrutinizes large rental real estate losses. The IRS reviews the returns of people that claim to be real estate professionals (and looks at your other income). The IRS will check to see whether you worked the necessary hours especially for those whose day jobs are not in the real estate business.
Taking early payout from a retirement account
If you take money out of your retirement account (like IRAs and 401(k)s), you are subject to a 10% penalty. Make sure to count this in your income appropriately on your tax return.
If you are going to claim an alimony deduction, make sure you satisfy all the requirements.
Gambling winnings and losses
Failure to report gambling winnings can draw IRS attention (they are notified of your winnings by casinos and other venues). Claiming large gambling losses can also be risky. You can deduct these only to the extent that you report gambling winnings.
Large cash transactions
The IRS gets reports of cash transactions in excess of $10,000 involving banks, casinos, car dealers, and other businesses, plus suspicious activity. You should know that banks and other institutions alert the IRS of transactions that are consistently under the $10,000 threshold.