We fear it more than we fear needles, spiders and childbirth combined. Trips to the dentist would be welcome by comparison. And yet, the IRS only audits around 1% of all individual tax returns annually. So while the odds are pretty low that your return will be picked for further scrutiny, nevertheless, we fear the possibility with an unmatched and largely unwarranted terror.
There are several triggers that are surefire ‘tells’ for an audit examiner – and the odds are that the more of these that you may have, the result is a higher likelihood of a full blown exam.
1. Income level
While the overall individual audit rate hovers slightly over 1% across all filers, it rises dramatically for those in higher income levels. Make $200,000 and your rate rises by a factor of about four times. For those of you lucky enough to be reporting income at $1 Million or more, your chance of audit roulette stands at about a one in eight chance.
2. Underreporting all taxable income
Technology can be a godsend or a curse, depending on how it is used. The reality is those January mailings of 1099s and W-2s you get are also reported to the IRS. Sophisticated technology and computer matching assists the IRS in determining if what you report on your return coincides with the information that all of the issuers reported to them. A mismatch sends up a red flag and causes the IRS computers to dig a little deeper. If you receive a 1099 showing inaccurate information, have the issuer file a corrected form with the IRS.
3. Deductions that set off alarms
Large charitable deductions
The IRS isn’t suggesting that you not contribute to charity; after all, legitimate contributions are a great write-off and give us that warm glow of helping our fellow man. However, if the charitable deductions you claim are disproportionately large compared with your income, it will be a signal. That’s because IRS computers (yes, those same ones that can match the 1099s and W-2s) keep track of the relative percentage of charitable contributions by income level across all filers. By following the rules, keeping supporting documentation such as receipts for cash or property, appraisals justifying valuations, and attaching Form 8283, you are less likely to be meeting with the examiner.
With so many people working from home offices, it is surely tempting to claim the home office deduction. The IRS has found great success, however, in increasing their tax coffers by finding abusers of this deduction. To be a legitimate deduction, the operative term is “exclusive use”. So if your home office is the dining room table that is used for Sunday family dinners, save yourself the aggravation and don’t claim the home office deduction. On the flip side, if you have been fortunate enough to be able to carve out space that you solely use to transact business, take the deduction.
Business meals, travel and entertainment
The IRS trains its agents to be especially diligent with certain ‘classes’ of filers. For new and seasoned agents, one of the classes that get their radar going is those who file as “Self-employed”.
Disproportionately large deductions for meals, travel and entertainment are ripe for audit as they frequently do not meet the substantiation guidelines. To qualify for meal or entertainment deductions, you must keep detailed records that document each expense by the amount, the place, the people attending, the business purpose and the nature of the discussion or meeting. Also, you must keep receipts for expenditures over $75 or for any expense for lodging while traveling away from home.
Claiming 100% business use of a vehicle
The IRS is actively on the lookout for discrepancies associated with the 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 of an automobile is like candy for IRS agents. They know that it’s extremely rare for an individual to actually use a vehicle 100% of the time for business, especially if no other vehicle is available for personal use. 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’ standard mileage rate, don’t try to double dip and claim actual expenses for maintenance, insurance and other out-of-pocket costs.
Writing off a loss for a hobby activity
In the game of audit roulette, one of the bullets is losses that ‘may’ be associated with a hobby. So if you are breeding the next Secretariat or are a Danica Patrick wannabe, your activity must be entered into and conducted with the reasonable expectation of making a profit. Large Schedule C losses are always audit bait, but reporting losses from activities in which it looks like you’re having a good time all but guarantees IRS scrutiny. Just make sure you run your activity in a businesslike manner and can provide supporting documents for all expenses
Taking higher-than-average deductions
Just as with the charitable deductions flag, if the other deductions on your return are disproportionately large compared with your income, the IRS may pull your return for review. Just make sure you have the proper documentation for your deduction when you claim it. There’s no reason to ever pay the IRS more tax than you actually owe.
4. Cash used to be king
Engaging in a cash intensive business
If you are a small business owner engaged in a cash intensive businesses (e.g., taxis, car washes, bars, hair salons, restaurants), you represent a tempting target for IRS auditors. Based on their experience, the IRS recognizes that there is a significant amount of underreporting in these types of businesses.
Engaging in excessive cash transactions
As a consequence of the several laws, RICO and the Patriot Act among them, the IRS gets 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. If you make large cash purchases or deposits, be prepared for IRS scrutiny.
Failing to report a foreign bank account
If you have an offshore account, particularly one in a known tax haven, the IRS is going to be all over you. They have had success getting foreign banks to disclose account information. 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.
Avoiding these likely audit traps will not guarantee that you will not by audited, but you will reduce the likelihood of being selected.