Originally posted on https://silvertaxgroup.com/irs-audit-red-flags/
In 2017, the Internal Revenue Service (IRS) audited only 1 in 160 individual returns. The number of people audited every year has been on a decline for several years now.
However, filing taxes is still a very stressful activity for most. This is because any mistake while filing can result in a full-blown audit by the IRS.
In this article, we shall look at the most common tax audit triggers so that you can avoid being a subject of further review by the IRS.
1. Computer System Triggers
Due to budget cuts, the IRS has had fewer field agents for the past few years. This has greatly contributed to the reduced number of audits per year.
To address manpower challenges, they developed a computerized system called the Discriminant Information Function (DIF).
The system scans every tax return received. It looks for duplicate information or figures that do not make sense in your returns.
These may be deductions and credits that do not add up or things such as two people listing the same person as a dependent.
For accuracy in identifying discrepancies, the system compares the returns of all the individuals in the same income bracket. Any issues flagged by DIF warrant further investigation by human agents.
2. Data Entry Mistakes
Audits can be triggered by simple errors such as misspelling your name, entering Social Security Numbers incorrectly and arithmetic errors.
Whenever data is being transferred from one point to another manually, there is a great risk of entering it incorrectly, transposing numbers and other errors.
When filing paper returns, make sure you triple check everything. Do so even if you used the services of a tax preparation company.
To reduce the risk of making errors, you can try filing electronically. When using the E-filing system, you will be able to limit manual entry as you can load important data directly from your W-2 and past returns.
The E-filing calculator will also reduce the chances of making arithmetic errors
3. Overstating Deductions or Significantly Disproportionate Deductions
When filing your taxes, the IRS allows you to deduct some expenses from your returns.
Good examples of such expenses include home office deductions, charitable deductions, and donations to charity. These deductions will lower your taxable income and thus reduce the amount of taxes you are required to pay.
Even with such deductions, there are people who are tempted to overstate these expenses in order to reduce their taxable income even further.
If the deductions or donations you post seem to be disproportionate or too much, they will raise red flags.
Always get a receipt for any large donations you make. Submit it together with your returns as proof.
Also, always ensure that the business expenses you deduct as you file are accurate and make sense. It is important to keep all your receipts in case you are required to validate your expenses.
The rules for home office deductions have been simplified over the past few years. However, claiming to have a home office may still lead to an audit.
Remember that the IRS receives copies of your mortgage interest as it does your income forms. Therefore, any claim you make should be in line with the information provided by your mortgage broker.
4. Overlooking Income
Companies and individuals are required by law to report remittances to the IRS, and the taxpayers receive the payments. Your employer is required to issue you with a W-2 for your earnings and also send it to the IRS too.
For independent contractors and freelancers, they must be given forms 1099-MISC. However, it is only used when they are paid over $600 for their services.
If you earn income from interest or dividends, you should expect forms 1099-INT or 1099-DIV at the end of the year. The IRS receives all these copies.
They receive information on all forms of income you receive. Even if you win the lottery or hit the jackpot at a casino, they will receive form W-2G.
The IRS receives information about all incomes received and payments issued. Failure to include any income will be detected by DIF and raise red flags.
Apart from a few exceptions, all your income is taxable. Make sure you keep track of the income you receive and report.
5. Significantly Increased Spending and Huge Cash Deposits
Businesses such as banks, financial institutions, and various others are required by law to notify the IRS anytime someone conducts large cash transactions. Generally, these involve $ 10,000 or more.
Anytime you start making such deposits or purchases, the IRS will become curious. This is especially if it does not match your reported income.
6. If You Earn a lot or Very Little
This is an approach that’s normally used for high-income earners. The IRS puts more focus on taxpayers they are sure owed additional taxes and there is a good chance for collecting.
Most of the audited taxpayers earn $ 200,000 a year or more with the bulk of them earning above $ 1 million.
The more income you earn, the more complex your tax returns become. As a result, there are higher chances for the returns filed to include errors.
High-income earners who slash their taxable income with deductions stand a greater chance of being audited.
7. Withdrawing from Retirement Funds
Even if you have not reached retirement age, it is not a crime to withdraw money from your 401K investment or IRA.
However, such action may trigger the IRS to audit you. It is not tax fraud to take early withdrawals but the IRS has discovered that most people who do so also make mistakes on their returns.
There is a tax penalty for early withdrawals that most people are not aware of. Unveiling such errors earn the IRS additional tax revenue. For individuals above 59 and a half years, withdrawals are not a big issue. They will only have to pay income tax on the distributions.
However, if you are younger, you will also have to pay a 10% tax penalty on the withdrawal. There are certain scenarios that you may be exempted from this tax.
However, you should not claim one unless you are sure you qualify. According to the IRS, this is what results in most of the mistakes that result in an audit.
8. You Are Self-Employed
There are many tax deductions that self-employed people and freelancers are entitled to. These include mileage deductions, home office deductions, travel, entertainment, and deductions for meals.
Such expenses should be compiled on schedule C and deducted from your revenues. This will determine your taxable income.
Based on your line of work, DIF will be on the lookout for deductions that are above the norm. On your tax returns, there are occupational codes.
The IRS uses these codes to make sure your expenditures match those of other people with your code.
Even if you use your car for business purposes, attempting to deduct all your mileage costs will raise flags. This is especially if you only have one vehicle. It is safe to assume you also drive for personal errands.
9. Running a Cash Business Makes You More Likely to Be the Subject of a Tax Audit
If you operate a cash business, you are likely not receiving forms 1099s from anyone. This makes you a subject of scrutiny by the IRS.
The businesses that fall in this category include barber shops, salons, restaurants, taxi services, bars, and car washes.
Cash businesses are given special attention as it is assumed that it is easy for the owners to receive the $50 payment and forget about it when tax season comes. Red flags go up when the income you report cannot sustain your lifestyle.
Though it may be difficult for the IRS to determine your lifestyle, they take tips from concerned citizens.
10. You Have Cash and Assets Abroad
There are countries that have more favorable tax laws than the US. Consequently, there are taxpayers that stash cash or buy assets in such countries for the tax benefits they will get.
Such individuals are of great interest to the IRS especially after they made improvements to their rules on overseas property and method of assessing such returns.
Some foreign banks are required to provide a list of American account holders to the IRS. Even when they are not obligated to do so, the IRS can access the account information from your offshore bank account.
They are likely to seek out this information if they feel you are liable to be taxed for the cash stored there.
If the total cumulative balance of your foreign accounts is more than $ 10,000 you are obligated to report it on the FinCEN form 114. Assets on foreign soil with a value of $ 50,000 and above should be reported on the IRS form 8938.
11. Wrong Filing Status
At times determining your correct filing status can be difficult especially if you are married and one of you is unemployed or self-employed.
Making the wrong choice when filling could trigger an audit. Changes in your marital status require you to change your filing status. Sudden changes can, unfortunately, put you under the scrutiny of the IRS.
The Key to Filing Taxes Accurately
Filing taxes does not have to be intimidating. Most people run into problems because they are not adequately prepared when tax season comes.
The secret is to start preparing early enough. Ensure that you keep proper financial records. When it comes to deductions, keep all the necessary receipts that will back your claims.