Sometimes extra attention is a good thing. But in the case of IRS auditors, the last thing you want is to stop them in their tracks when they’re looking at your return.
The Internal Revenue Service doesn’t have the manpower to scrutinize every return. Instead, it looks for tell-tale signs that could mean there’s a reason to dig deeper. Call them red flags or triggers, but a certain set of circumstances is likely to make the IRS hit the pause button on what could be the beginning of problems for you.
The good news, though, is that the overall individual audit rate is about one in 143 returns — but the odds increase dramatically as your income goes up.
Sandra Block, senior associate editor at Kiplinger Personal Finance Magazine, says IRS statistics for 2016 show that people with an income of $200,000 or higher had an audit rate of one out of every 59 returns. The stakes are even higher for those who report $1 million or more of income. “There’s a one-in-17 chance your return will be audited. The audit rate drops significantly for filers making less than $200,000: Only one out of 154 of such returns were audited during 2016, and the vast majority of these exams were conducted by mail,” Block says.
Aside from making the big bucks, what else puts you in the spotlight? Here’s a list of potential red flags, from Kiplinger and other tax experts:
- Large charitable deductions. Giving to charities can be a great tax write-off, but if your donations are disproportionately large compared to your income, expect the IRS to ask for verification. The IRS tracks the average charitable contribution for folks at every income level. Donations that exceed the expected amount are seen as suspicious.
“Just keep detailed records of your giving, including receipts for all contributions of cash and property. Failing to get an appraisal for a donation of valuable property, or forgetting or incorrectly filing a Form 8283 for non-cash donations greater than $500, puts an even bigger audit bull’s-eye on your back,” says Scott Sanders, a CPA at Sanders Thaler Viola & Katz in Jericho.
- Overstating business deductions. Taking business deductions that seem disproportionately large compared with your income is an invitation to the IRS to investigate. Same goes for reporting an operating loss for your business. If you’ve got the proper documentation for the write-off, go for it, but know that you may be called upon to back up your story.
“The IRS knows that certain tax deductions are abused frequently. People claim a computer and desk as a home office deduction, family vacations as ‘business travel,’ or 100 percent business use of a vehicle, which the IRS knows is very unlikely to be true,” Sanders says. “People like to get creative with the deductions they try to claim, but such thinking, or cheating as the IRS would say, can backfire.”
- Failing to report your full income. The IRS receives copies of all W-2s and 1099s that you receive, so forgetting to report all of your income may result in an audit. “Even if you don’t receive a 1099 for a specific payment, you are still required to report that income, no matter how small it is,” says Joshua Zimmelman, president of Westwood Tax & Consulting in Rockville Centre.
- Not reporting a foreign bank account. All U.S. citizens and residents must report the existence of overseas bank accounts if they total more than $10,000 at any time during the year. Even if these accounts generate zero income, they need to be reported. The penalties for not reporting are huge — they can run as high as 50 percent of the account’s value, plus penalties.
“How will the IRS know about the accounts if you don’t tell them? Almost every country in the world has an agreement to report ownership by U.S. persons of foreign accounts to the IRS. It’s a small world after all,” says Denis Brager, founder of the Brager Tax law Group in Los Angeles.
- Alimony payments. If you pay alimony, you may be able to deduct the amount you pay on your taxes. However, the alimony payments must be covered in your divorce or separation agreement and meet certain requirements. If you try to deduct alimony without properly meeting the requirements, it may trigger an audit.
“If you receive alimony, it must be reported as taxable income. If two ex-spouses unevenly report the payment and receipt of alimony, it may cause one or both parties to be audited,” says Zimmelman.
- Not reporting stock sales. “We are constantly helping clients respond to tax notices for forgotten stock transactions. It doesn’t matter if you later reinvested that money, all sales of stock [excluding in a retirement account] must be reported. When you get a tax notice, you will have costs to respond and owe any back taxes plus interest and possibly penalties,” says Gail Rosen, a CPA in Martinsville, New Jersey.
To avoid this, make sure you report all stock sales on your return. “If you realize you missed a sale, go back and amend your return because you will be caught,” Rosen says. “Make sure your brokerage statements have your cost basis so you report the correct net gain or loss.”
- Writing off a loss for a hobby. You must report any income you earn from a hobby, and you can deduct expenses up to the level of that income. “But the law bans writing off losses from a hobby. To be eligible to deduct a loss, you must be running the activity in a businesslike manner and have a reasonable expectation of making a profit,” Block says.
- Taking an early IRA or 401(k) payout. The IRS wants to be sure that owners of traditional IRAs and participants in 401(k)s and other workplace retirement plans are properly reporting and paying tax on distributions. Special attention is given to payouts before age 59½, which, unless an exception applies, are subject to a 10 percent penalty on top of the regular income tax.
An IRS sampling found that nearly 40 percent of individuals scrutinized made errors on their income tax returns with respect to retirement payouts, with most of the mistakes coming from taxpayers who didn’t qualify for an exception to the 10 percent additional tax on early distributions, Block says.
- Hiring family members. It is completely legal to hire your family, but sometimes this is used as a cheaper way of withdrawing more money from a business, since salary is a tax-deductible business expense.
“If you’ve employed a close family member, especially one that lives in your household, just make sure you’ve got documentation to prove that they’re a legitimate employee and the money your company is paying them doesn’t go right back into your bank account,” Zimmelman says.
Filing an estate tax return
While estate tax returns are rare — they are only required if an estate is worth $5.45 million or more; 35,619 were filed in 2015 — the IRS looks these over carefully.
The bigger the estate, the greater the odds it’ll be flagged for an audit. “More than 16 percent of estate returns with assets between $5 million and $10 million were examined, and 31 percent of returns with assets exceeding $10 million were audited,” Brager says.
Says Block, “Taxpayers shouldn’t be afraid to claim all of the tax breaks legally available to them. But if you had a high income, claimed a large deduction for charity or mortgage interest, or received a windfall last year, make sure you have good records. It’s also a good idea to hire a tax preparer who has experience with IRS audits. Only enrolled agents, certified public accountants and attorneys can represent you during an audit.”
Correction: Joshua Zimmelman’s surname was spelled incorrectly in an earlier version of this story.