Why are some tax returns audited by the IRS? There are a whole host of reasons but only about 1% of all returns actually are audited. So the odds are pretty low for most taxpayers. However, the chances of audit or questions from the IRS can increase based on various factors including omitting income that has been reported to the IRS directly by third parties like a 1099 or a W-2, certain types of deductions and credits, foreign holdings and math errors.
Although there is no sure way to avoid an audit, here are 12 red flags to be aware of:
• Failure to report all taxable income. Make sure that you have included all income from 1099s and W-2s. If you receive an incorrect form from a third party, ask them to correct it BEFORE filing your tax return.
• Returns that have claimed the home buyer credit. There has been a lot of fraud in this area. Make sure you attach your settlement statement to your return if you claim this credit. The IRS is also monitoring the recapture of this credit by following real estate transactions reported in public records.
• If your charitable contributions are comparably high in relation to your income, this could be a red flag and if you do not file a form 8283 for noncash donations over $500 the chances for audit increase.
• The IRS likes to audit the home office deduction because they often make an adjustment to a tax return when they do. For this deduction the space must be used exclusively and on a regular basis as your principal place of business. This can make it difficult to claim the guest bedroom or the family's TV room.
• Business meals, travel and entertainment on schedule C is a gold mine for IRS audits. Large write offs here will set off alarm bells to the IRS. Agents know that many taxpayers fail to satisfy the strict substantiation rules for these expenses. You must keep detailed records of the amount, place, persons attending and business purpose for all expenses.
• Another area the IRS is successful in auditing is the business use of an automobile. Again, taxpayers are aggressive with their claim and often do not have the required substantiation. It is extremely rare for a vehicle to be 100% business. Detailed documentation and a less aggressive approach are key in this area.
• If your schedule C is a loss generating activity, you may have trouble with the IRS. The IRS can sniff out a hobby that is really not a trade or business. If you are trying to make your hobby into a business, your intention from the beginning must be to make a profit. So make sure you run your business in a business-like manner.
• Cash intensive businesses are often at risk. The IRS has developed a new guide for agents to use when auditing cash businesses and looking for unreported income.
• Failure to report a foreign bank account can lead to severe penalties and the IRS has made this a top priority. Make sure you report all income from these accounts such as interest and dividends on your returns.
• Currency transactions, like gambling winnings, are a valuable source of audit adjustments for unreported income. If you are a person who makes large cash purchases or deposits be prepared for IRS scrutiny.
• Math errors are rare if you are using a tax preparation software but if you are preparing your own return they are common. If you make a math error, you will definitely hear from the IRS about it and it can often lead into a tax audit.
• If any deduction on your return is disproportionately large compared to your income, the IRS takes notice. It has formulas that it uses in processing returns. Screeners of returns pull out returns that don’t meet the norm. If you have proper documentation, no need to worry but be prepared for IRS questions.
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