No one really wants to be audited by the IRS. It’s time consuming, and quite frankly, a headache. You’ve probably wondered at some point who gets audited and why, as well as how you can avoid it. While there is no fool-proof way to avoid an audit; however, there are ways to reduce your chances.
The IRS audits slightly more than 1% of all individual tax returns each year because they do not have the resources and personnel to examine more than that. They do, however, look to audit the returns that are more likely to uncover overstated deductions, unreported income, false claims, or taxpayers that haven’t filed tax returns in a while.
The chances of audit are due to several reasons: your annual income, an omission of income when the IRS has filings and notifications of income you received, the types, the size or ratio of the deductions or losses you claim, whether you work for a company and in what field you work, if you own a business and the type of business you own, and if you own foreign assets or bank “offshore.” A sloppy tax return, discrepancies between state and federal tax returns, math errors, or big fluctuations in reported earnings from one year to the next year may also trigger an IRS inquiry, but may not expand into a broad audit.
Odds are that you will fall into the 98% of non-audited tax returns, in order to do what you can to stay out of the group that does have an IRS audit – there are some IRS red flags to avoid, if you can.
The Most Common IRS Red Flags that could trigger a Tax Audit:
1. You make too much money – High-income filers have a higher chance of being audited, though there isn’t much you can (or would want to) do about this. The overall individual audit rate is about 1.11%, but IRS audit rates for 2011 taxpayers with incomes of $200,000 was 3.93%. For taxpayers making over $1 million dollars, the odds increase to a one in eight chance of an audit.
2. You fail to report a foreign bank account – The IRS is rabidly-focused on any individuals who have offshore bank or securities accounts –especially if they are in tax haven countries.
3. You make too little money — If your income is lower than others in your field, it could trigger an audit.
4. Big changes in income — Most people do not vary their income dramatically year-to-year; so a big change could indicate that your wages were underreported in a year of low income. This may cause the IRS to look more closely at your returns.
5. Not reporting all taxable income – Since the IRS gets copies of all 1098′s, 1099′s, and W-2′s, if your return doesn’t match the records sent to the IRS from your employers or clients, you are more likely to stand out to them.
6. Owning your own business – This group is a targeted group. Revenue agents often feel they can almost always find overlooked or unpaid tax here – for this reason, it’s important to keep your records in good order.
7. A home office deduction – The home office red flag isn’t as big an issue because so many people work at home, as freelancers or telecommuters and legitimately choose to take this deduction. It does remain a red flag, so in an audit, the IRS will likely want to check out your home office and literally measure your office to be sure you are being accurate.
8. You are a sole proprietor – Sole proprietors are even more of a target than incorporated business owners, along with all Schedule C filers. It’s worthwhile to consider incorporating where a Schedule C is not used.
9. You own a mostly-cash business – This is the most difficult business situation for business owners, and the IRS does examine this class very closely. The best way to deal with this is to be sure to keep good records.
10. Engaging in large currency transactions – The IRS gets many reports of cash transactions in excess of $10,000 involving casino visits, banks deposits and withdrawals, and via car dealers and similar cash businesses. Many banks also fill out an IRS reporting form for cash withdrawals of over $5,000, but never inform their customers that they do it; so be aware that these transactions may be monitored and called into account.
11. Claiming higher-than-average deductions – If the deductions are unduly large on your tax return, compared with your income, the IRS computers flag your return for human review and possibly with a follow-up audit.
12. You have family members on business payroll — While there is nothing illegal about hiring a family member, you must be able to prove they are doing the work.
13. Business deductions that really aren’t — Be very careful to keep your business and personal expenses separate as much as possible. You may not realize it, but the auditors will have the birth dates of your family members, possibly your wedding date, and are trained to look for significant purchases and expenses in the days immediately prior to birth dates, anniversaries, Christmas, etc. and in an audit, will verify large-dollar purchases, travel, and that entertainment expenses are really business-related.
14. Deducting business meals, travel and entertainment – This falls under the same group as claiming business deductions that really aren’t. Just be sure you document how these are legitimate expenses for your business, and be conservative with the deductions.
15. An illegible or wrong social security number – Make sure your social security number is easy to read – along with the rest of your return; illegible returns account for many needless audits.
Our tax representation firm of Mike Habib, EA in Whittier California provides IRS tax Audit representation help for clients throughout Southern California including Norwalk, Santa Fe Springs, Downey, Pico Rivera, Montebello, Hacienda Heights, La Habra Heights, West Covina, La Habra, Brea, Fullerton, Yorba Linda, Cerritos, La Mirada, Lakewood, Anaheim, Santa Ana, Long Beach, Compton, Torrance, Los Angeles, Pasadena, Beverly Hills, Santa Monica and throughout Los Angeles County, Orange County, Corona, San Bernardino County, Riverside County, the Inland Empire, the San Fernando Valley and the San Gabriel Valley.
We will continue part 2 of 2 on our next post.