The good news is that, on the average, very few people get audited by the IRS. Better still for some of us, the less money you make, the less likely you are to be audited. According to the IRS, for Tax Year 2009, if you made less than $200,000, you had a slightly lower than 1% chance of being audited. If you made more than $200,000, your odds jumped to almost 3%. If you earned over $1 million, bump that frequency up to over 6%.
The bad news is that the chance still exists for all of us, and despite the general professionalism of the IRS, an audit is rarely a pleasant experience. To avoid or , stay clear of these top 16 things that raise red flags with the IRS.
Taxpayers often ask why the CRA commenced an audit or whether taking a particular step might target them for a future audit. These are reasonable concerns, since the CRA’s approach to audit selection is generally not random, but rather based on risk assessment.
An IRS audit can be a nightmare. Thankfully, only a small percentage of tax returns are audited. Wondering if your return is audit bait? It’s not black magic; the most egregious red flags are well known. Here are the top tax return warning signs to watch for and how to further reduce your chances of getting picked.
Certain red flags in a tax return are sure to draw scrutiny by the IRS. Some are easy to sidestep. Others, can’t be helped.
The Internal Revenue Service uses a combination of automated and human processes when selecting which tax returns to audit. All tax returns are compared with statistical norms, and those with anomalies undergo three layers of review by personnel. Audits then occur either by mail or in meetings at taxpayers’ places of business. They can be unpleasant and are sometimes unavoidable.
Tax Audit Red Flags & Triggers You Should Know
1. Math Errors
Your income tax return gets entered into an IRS computer, one way or another. If you have made a math error, you will automatically get the computer’s attention. This is one of the most common IRS audit triggers. This is why, if you do your own return, it may be a good idea to run it through a tax program to check your math.
2. Failing to report all taxable income
Another simple trigger to IRS audit is to report income differently on your return than the people who pay it to you report it, via W-2 form and 1099s. The IRS computer will try to match all of your payers’ numbers with your numbers, and when they can’t, you get a letter. So gather all of those envelopes stamped “IMPORTANT – TAX RETURN DOCUMENTS,” and tick off all of those numbers. . The most tempting audit red flag is when you don’t follow the law, such as failing to declare all of your taxable income. It’s not like you can easily hide it; after all, the IRS gets a copy of all of your W-2s and 1099s.
3. Not Just How Much, But Also How
As I noted above, your income level can affect your odds of being audited and raise a red flag, but how you earn that income is also relevant. People who work in jobs where a significant amount of unreported cash changes hands, such as restaurant wait staff or salon workers, garner more interest.
The CRA may commence an audit based on information obtained during the audit of a third party, or because of a referral from another CRA department, other government organizations or informants. Sometimes estranged family members share information with the CRA, including estranged spouses seeking leverage in a family law dispute.
5. Not using fair market value for residential real estate rentals:
Where real estate rentals yield no income or losses, the CRA may suspect that the property is being rented for less than market-value rent to a non-arm’s length person. The CRA may rely on property tax and interest expense information to ascertain the value and market rent for a property.
6. Discrepancies between tax filing position and filing positions for similarly situated taxpayers or private corporations:
The CRA may compare: corporate tax returns amongst similar businesses; the relationship of purchases, sales and GST/HST remitted to other businesses in the same industry to ascertain whether remittances are reasonable; and tax returns of shareholders of a private corporation to the corporation’s tax filings. Therefore, filing positions which are not consonant with expectations for an industry, or which are not consonant amongst shareholders and their private corporations, may attract an audit.
7. You have a sketchy tax preparer
Sometimes your tax preparer does something which can be the reason for IRS audit trigger. If a preparer promises unusually high refunds without asking to see proper documentation for deductions and credits, don’t be fooled, said Vincenzo Villamena, CPA and managing partner at accounting firm Online Taxman.
8. Typos and Entry Errors
It seems like a silly way to get audited, but if your numbers don’t match the numbers the IRS has on file, it raises a red flag for audit. CPA Andrew Porter tells USA Today you should even double check numbers entered by a tax professional:
You’re legally responsible for the information on your return no matter what a preparer tells you, so make sure to look over your return before it’s sent to the IRS.
“Preparers can promise you the world, but then when they deduct a bunch of stuff they shouldn’t, you’re going to be the one stuck with an audit,” said Villamena. Also, you’ll be required to repay any money you receive fraudulently.
9. Making unusually high charitable deductions.
One of the benefits of reviewing millions of tax returns every year is that the government has access to statistical data that can accurately raise a red flag for IRS audit. For example, charitable donations that don’t conform to expected values for your income level. Not only should you be careful to accurately asses your charitable donations (such as if you give away personal property to Goodwill or similar organizations) but you should do it properly — such as filing for 8283 for donations over $500.
10. An anomalously high income.
If your income is very high, congratulations. And while there’s not much you can — or probably even want to — do about that, you should be aware that for incomes over $200,000, the audit rate is almost 4 times higher than the national average.
11.The Earned Income Tax Credit
Last year, the IRS said tax returns that claim the Earned Income Tax Credit are twice as likely to be audited. According to the Wall Street Journal, “improper claims” of this credit cost the government over $10 billion a year.
Sometimes these “improper claims” are fraud, but sometimes they’re honest errors:
“The EITC’s complex rules help lead to high error rates by taxpayers and even paid preparers.”
If you or your preparer has claimed the EITC, read the IRS guidelines and double-check that you qualify.
12. Claim a loss on a hobby.
By definition, a hobby is not pursued for profit. But that doesn’t stop some taxpayers from trying to write off expenses for their dog showing, comic book trading or other “business.”
13. Failure to report a foreign bank account can lead to severe penalties.
14. You own a business
The IRS tends to look extra closely at taxpayers reporting businesses on Schedule C forms because there’s more room for fudging.
“The IRS primarily targets small businesses, especially sole proprietorships, and cash industries like pizza parlors and coin-operated Laundromats with opportunities to hide income and skim profits,” said Certified Tax Coaches’ Molina.
If you own a business, report every single bit of income you’ve received. If you’re still worried about being audited, you may even want to reorganize your business as a corporation or partnership (which means you’re not required to file a Schedule C) instead of a sole proprietorship, said Molina.
And if you’re flagged for an audit, the IRS will be skeptical of any business that looks like it’s actually a hobby, especially if you are deducting a loss on your return.
15. Claiming business use of a vehicle.
Like your home office, claiming business use of a vehicle is a treasure trove for the IRS when audit hunting. That doesn’t mean you shouldn’t claim your vehicle if your use of it is valid, but be very wary in particular of claiming 100 percent business use. Very few people can successfully claim complete business use of a car they own or lease, so keep good and thorough logs of how you employ your car.
16. Participating in aggressive or high risk tax strategies:
The CRA has dedicated audit resources to detecting and reassessing a number of issues, including: artificial capital losses; loss trading transactions; surplus stripping; offshore investment accounts; donation arrangements; withholding tax; section 85 rollover transactions; permanent establishment/residency issues; interest deductibility; RRSP appropriations; and tax free savings accounts.
What to Do If You’ve Been Audited
What should you do if you are audited? Be honest with the auditor and respond to all inquiries as quickly as possible. Don’t be afraid to show all of your documentation. If possible, hire a qualified accountant and/or represent you.
In the unfortunate case that you’ve been audited, there are several steps to take. First, respond to your letter promptly. “You can ask for more time to gather the paperwork and forms.
Most of the time, the IRS is simply asking for a piece of documentation. But, in some cases, you might consider representation:
If you can’t find the information they’re looking for, you’ll probably want to call a professional to advise you on your next move. And if you’ve been called in to meet with an agent, you should almost certainly bring in outside help ‘Don’t start from the position that everything can be bargained down, noting that if you’re found to have underreported your income, there’s not much room for negotiation. Still, ‘once the audit is done, it can always be appealed, so they’ll cut you a deal that will make you happy because they don’t want it to drag on.'”The IRS also provides information on audits, and you can fill out Form 911
Audits have and will remain a part of the tax collection process for a long time to come, but that doesn’t mean that you have to be among the “lucky” few to be chosen. The key to avoiding an audit is to be honest, document your deductions, donations and income. (To find out more about the auditing process and how to come out on top, read Surviving The IRS Audit.)
Defense Tax has got you covered
When you file a tax return, you automatically receive access to our Support Center, which can help you respond to the most commonly received audit inquiries. The Defense Tax also provides free audit guidance from a trained tax attorney, CPA ‘or’ tax professional to help you understand why the IRS contacted you and to answer your audit questions. For those who want even more protection, DefenseTax offers Audit Defense, which provides full representation in the event of an audit, for an additional fee.
Now that your tax return has been filed, you’re probably ready to close the books on 2014. But what are the chances that the IRS might pluck your return from the mountain of paperwork for what one author calls “the ultimate curse of a civilized society — a tax audit”?
This Kiplinger calculator will give you the answer, based on official data from returns examined by the IRS in 2014