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Red Flags that Could Trigger an IRS Audit Karen Jou, CPA-Owner
We now know that the IRS audit rate dropped to
0.4% of all individual tax returns. That works out to
approximately one return out of every 250 filed – and
most were low-level correspondence audits. The
IRS is auditing fewer returns due to federal budget
cuts, and because it has not yet replaced experienced auditors who have retired.
Still, that doesn’t mean you can drop your guard when it comes time to file your
return. When returns are filed, they’re scanned into the IRS computer system,
which is designed to detect anomalies. If there is an anomaly, that creates a “red
flag.” The IRS is more likely to eyeball your return if you claim certain tax breaks,
deductions, or credit amounts that are unusually high compared to national
standards; you are engaged in certain businesses; or you own foreign assets.
It’s impossible to predict if your return will be selected for an audit, but you
would do well to keep the most common red flags in mind:
1. Failing to report all taxable income
Over the years the IRS has received more information from third parties — not
only from W2s, 1099s, and brokerage statement information, but also from flow
through entities. The computer system compares that information to the return.
If there is a mismatch, the computer generates a bill.
2. Earn a lot or very little
The more you earn, the higher the chance the return will be audited. The majority
of returns audited are from taxpayers who earn more than $500,000. The IRS has
limited staff, and if there is a change on a wealthy taxpayer’s return as a result of
an audit the money owed will be greater and the possibility of collection rises. On
the other end of the spectrum, taxpayers who reported no adjusted gross income
are also flagged, and the audit rate for this group is approximately 2%. The IRS
may do a cost-of-living analysis to see how you were able to live on hardly any
income. Again, that’s much higher than other income levels.
3. Excessive deductions or credits
The IRS will compare the itemized deductions and credits taken to the average
totals for similar taxpayers in the same income bracket. If yours is higher, the IRS
may look at the numbers more carefully.
4. Schedule C filers
Sole proprietors and freelancers are entitled to a handful of deductions that
most other taxpayers cannot claim, such as home office deductions, mileage
expenses, meals, and entertainment expenses — and IRS agents know that
self-employed individuals tend to claim excessive deductions. Schedule C filers
also sometimes under-report income, so the IRS looks closely at businesses that
primarily operate with cash or show a loss. For those businesses, the audit rate
in 2019 was between .08% and 1.6%.
5. Non-filers
Addressing high-income non-filers is now the IRS’s top strategic priority. The
emphasis is on individuals who earned more than $100,000 but did not file a tax
return. As previously mentioned, the IRS compares information they receive from
multiple sources to see if returns were filed.
6. Claiming 100% business use of a vehicle
The IRS knows that it is rare for someone to use a vehicle for business purposes
100% of the time, especially if they don’t own another vehicle for personal use.
The IRS also targets heavy SUVs and large trucks used for business because these
vehicles are eligible for more favorable depreciation and expensing provisions.
The higher the business use percentage, the greater the IRS scrutiny will be.
7. Claiming a loss on a hobby
You can take a loss on a business, but you cannot claim a loss for a hobby. For a
business, the reasonable expectation is to make a profit three out of every five years. If
you have a hobby that is set up as a business, make sure to keep supporting documents
for income and expenses. If you have multiple years of losses on your Schedule C and
you have a lot of income from other sources, the IRS will look at this activity more
as a hobby – particularly if you do not depend on the income to make ends meet, or
you do not devote the necessary time, effort, and money to maximizing your profits.
8. Home office deduction
Due to the COVID-19 pandemic, many people worked from home in 2020. But most
people will not be able to claim the deduction because it’s not available to employees.
Prior to 2018, certain employees were able to claim the home office deduction as a
non-reimbursed business expense subject to 2% of adjusted gross income.
The deduction is still available to self-employed individuals and independent
contractors who use a room or space “regularly and exclusively for business.”
You do not need to own a home — renters can also claim the deduction. You
can claim the deduction through actual expenses incurred, or use a simplified
method, which is limited to $5 per square foot with a maximum deduction $1,500
9. Taking an early payout from an IRA or 401(k) account
Special attention is given to payouts before age 59½. Unless an exception applies,
these withdrawals are subject to a 10% penalty on top of regular income tax. With
so many jobs eliminated in 2020, a lot of people
took money out of their retirement accounts.
10. Engaging in virtual currency transactions
The IRS uses pretty much everything in its arsenal
to trace activities of taxpayers who sell, receive,
and trade or otherwise deal in bitcoin or other virtual currency. There is now a
question on page one of the 1040 return asking about virtual currency activity.
11. Failing to report a foreign bank account
This has been an issue for many years, particularly with taxpayers who
have money in nations with more favorable tax laws than the United States.
Some foreign banks are obligated to provide the IRS with lists of American
clients. There is also a question on Schedule B about foreign bank accounts.
If you have more than $10,000 in a foreign account, you are required to file
FinCEN Form 114. Foreign assets that amount to more than $50,000 must be
reported on IRS Form 8938.
12. Claiming the American Opportunity Tax Credit (AOTC)
The cost of a college education continues to rise faster than the cost of inflation.
The AOTC is worth up to $2,500 per student for the first four years of college.
Forty percent of the credit is refundable, meaning that even if you don’t owe any
tax, you get the money back. There are income limitations, and the student must
be enrolled at least half-time. Eligible expenses include tuition and books and
required fees, but do not include room and board.
You’ll run into trouble if you take the credit for more than four years, omit
the school’s ID number on Form 8863, or take the credit without being eligible
13. Engaging in cash transactions
Under the Bank Secrecy Act, various types of cash transactions in excess of
$10,000 are required to be reported. The goal is to thwart illegal activities. So, if
you make large cash purchases or deposits, be prepared for IRS scrutiny
Conclusion
The above list is not intended to be all inclusive; it’s simply to make you more
aware of certain activities that can lead to IRS audits. Working with us can help
mitigate the risk of being audited — and if you are audited, we are here to help
defend you against any potential adverse adjustment.
Karen Jou, CPA- Owner of HR Block offices located at 41-18 Crescent St. and
47-46 Vernon Blvd., LIC. If you have any questions or require additional
information, please call Karen at 718-707-0295.
25-59 Steinway Street, Astoria, NY 11103
718-278-3900
johnjciafone@yahoo.com
NYS
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31-53 Steinway Street, Astoria | Studio #400
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