What Are The Biggest Red Flags For IRS Audits?
Ever wonder why some tax returns get audited, but other’s don’t? The fact is that the IRS is understaffed and underfunded, which means it has to choose carefully the tax returns it audits.
Here are ten of the most common factors that the IRS uses to trigger an audit.
Audit Red Flag #1: Making Lots of Money
The audit rate is on average very low, with the IRS auditing less than 1% of all tax returns each year. However, your odds of getting audited climb drastically higher the more money you make. Taxpayers who make more than $200,000 are more than 4x more likely to get audited than taxpayers who make less than that amount (3.4% audit rate -vs- .08% audit rate). And for taxpayers who make more than $1,000,000 a year, the odds are even worse. The IRS audits 11.1% of tax returns with more than $1,000,000 of income — that’s more than 10x the average audit rate.
Audit Red Flag #2: Running a Small Business
The IRS audits small businesses and self-employed individuals more than any other category. Why? Because this group is thought to be responsible for nearly $500 billion of tax avoidance each year, due almost entirely to unreported income. This is especially true for cash intensive businesses, which is why the IRS has special audit guides for use on small businesses to uncover unreported income.
Audit Red Flag #3: Unreported Income
The IRS receives a Form W-2 for every wage earner in the United States, as well as various Form 1099s for other types of income. This makes it very easy for IRS computers to check to make sure the majority of taxpayers of accurately reporting their income. Missing a W-2 or 1099 on your tax return is an easy red flag and audit trigger.
Audit Red Flag #4: Large Charitable Deductions
Unusually large charitable deductions on your tax return is a very common audit trigger. This is because there are special rules for deductions of over $250, and the IRS knows few taxpayers bother to comply with them. This makes it easy pickings for additional tax revenue by focusing on these returns.
Audit Red Flag #5: Large Misc. Itemized Deductions
Closely related to the issue of large charitable deductions, large miscellaneous itemized deductions on Schedule A of your tax return is also a major audit red flag. This is because the IRS has very accurate data on the average size and amount of various deductions thanks to the 300 million tax returns it receives every year. Using this data, the IRS can quickly tell if your deductions are too large for your income bracket, which might be enough to trigger an audit of your return.
Audit Red Flag #6: Earned Income Tax Credit
The earned income tax credit if fully refundable — which means that you can use it to get a larger refund than you originally paid in taxes. As one of only a few such credits, it’s a popular one to abuse in order to increase the amount of a tax refund. Tax returns claiming the Earned Income Tax Credit are 2x more likely to get audited than those that don’t.
Audit Red Flag #7: Home Office Deduction
The home office deduction is a favorite audit trigger of the IRS. Over the years and through the course of thousands of audits, the IRS has discovered that most taxpayers claiming the home office deduction do not actually qualify for it. This is due to surprisingly strict requirements that most taxpayers don’t realize prevent them from taking the deduction. As a result, the IRS loves to audit tax returns with the home office deduction because it provides an easy way to increase tax revenue.
Audit Red Flag #8: Rental Losses
For the most part, losses from rental properties are not deductible. This is because of the rules against “passive activity losses” aimed at preventing tax shelter schemes like the ones that were popular in the 1980’s. However, there are exceptions and many taxpayers try to fit their rental activity into them in order to deduct their rental losses each year. This leads to easy pickings for the IRS, who strictly construe these exceptions — especially the real estate professional exception.
Audit Red Flag #9: Multiples Years of Business Losses
It’s no secret that losses from a legitimate business are deductible on your tax return. It’s also no secret that taxpayers like to claim they have a “side business” in order to get special deductions, while never really pursuing a profit from the business. This is why the IRS uses a “three year rule” to test whether a side business is really a legitimate one. Under this rule, a business that loses money for more than three years in a row is assumed to be a hobby — in which case the losses are no longer deductible. And because it’s no problem at all for IRS computers to check the profit history of a taxpayer’s Schedule C, this is an easy audit red flag for the IRS to use.
Audit Red Flag #10: Underpayment of Taxes
Last but not least is the underpayment of taxes. The IRS generally understands that unexpected things happen and sometimes taxpayer can’t pay their tax on time. However, a taxpayer who is consistently underpaying and incurring large tax debts raises a major red flag in the eyes of the IRS, who will want to know why the taxpayer is not doing proper withholdings or estimated tax payments.