Many taxpayers ask, "How can I avoid an IRS audit?"
There’s no 100% guarantee you won’t be picked, because some tax returns are chosen randomly. However, completing your returns in a timely and accurate fashion with your trusted tax advisor certainly works in your favor, and it helps to know the red flags that might catch the attention of the IRS.
Before we get started, let’s point out that you should maximize all legitimate deductions to help minimize your tax liability. Don’t be afraid to take a deduction that you are entitled to just because you fear an audit.
What are your chances of being audited? For individuals, it depends on your income. Generally, the higher your income, the better your chance.
What entries on your return are likely to result in a letter from the IRS? Here’s a list of 23 items some tax preparers believe can trigger an audit. Some items only apply to individuals or self-employed people who file a Schedule C, while others apply to both individuals and businesses. In some cases, items are likely to only generate a letter from the IRS requesting documentation for the item.
1. Outsized Charitable Contributions
The IRS publishes data on the average size of charitable contributions for various income levels. If you take a deduction for an amount that is much larger than the averages, you could hear from the IRS.
2. Large Property Contributions
Significant charitable contributions of property require an appraisal and certain return attachments. Appraisals are often challenged by the IRS.
3. Unmatched Alimony
For example, if you take a deduction for $24,000 of alimony, your ex-spouse should be reporting $24,000 of income.
4. High Mortgage Interest
The maximum amount of qualified home indebtedness is $1.1 million (including home equity loan). A mortgage interest deduction that’s in excess of a certain percentage of the debt limit could indicate an excessive deduction.
5. Unreported Income
Failure to report gambling winnings, interest and dividends, non-employee compensation (1099-MISC), K-1 items, etc. may just trigger a letter and bill from the IRS — or it could generate an audit.
6. Unreported Income from Crowdfunding
Entrepreneurs, artists, charities, and others may find it easy today to raise money on the internet through crowdfunding websites.
If the money starts rolling in, these individuals and organizations likely have to report it to the IRS as taxable income. (Expenses associated with the activities can be claimed as deductions.) Many people raising money online view their endeavors as non-taxable hobbies. This could eventually result in an IRS audit.
If you’re involved in crowdfunding, seek the guidance of your tax advisor to ensure your activities are properly reported on your tax return.
7. Gambling Losses
You’re allowed to deduct losses on Schedule A up to the amount of your winnings, but the IRS knows that many taxpayers don’t keep the required records.
8. Miscellaneous Itemized Deductions
Breaking the 2% of adjusted gross income threshold is difficult, so large miscellaneous, itemized deductions may perk the interest of the IRS.
9. Foreign Bank Accounts
Checking the box indicating that you have a foreign bank account on Schedule B could increase your chances of an audit. However, not checking the box when you should could, too. The IRS continues to get information on many foreign bank accounts.
10. Unreimbursed Employee Business Expenses
These expenses may be deductible, but substantial amounts are likely to raise questions because they are frequently reimbursed by an employer. If the expenses involve travel and entertainment or auto usage, your chances of hearing from the IRS may increase further.
11. Cash Transactions
Banks and merchants are required to report cash transactions in excess of $10,000.
12. Rental Losses of a Real Estate Professional
A qualifying individual can deduct rental losses in excess of the usual $25,000 limit. Meeting the required time limit involved in real estate activities and substantiating it isn’t easy. Checking the box on Schedule E could increase your audit chances.
13. Casualty Losses
This can be a complicated area where appraisals and other outside information may be required.
14. Bad Debt Losses
Again, this is often a complex area. Many taxpayers lose on this issue because they can’t show a bona fide debt existed or that a loss occurred in an earlier or later year.
15. Home Office
If you use a portion of your home exclusively for your business, you can deduct the expenses and depreciation associated with the space. However, you have to show the business connection and that the space was used exclusively for business. Both can be challenged by the IRS. The tax agency can also question the expenses involved in a home office. There's plenty of opportunity for an IRS auditor to make adjustments. In general, the higher the percentage of the home claimed for business, the greater your audit chances.
16. Day-trading Losses
Claiming to be a stock market day trader and taking losses on Schedule C is a red flag.
17. Net Operating Loss
If your business (sole proprietorship, S corporation, partnership) has losses, you may have a net operating loss (NOL) that can be carried back or forward to offset income in other years. You may be asked to substantiate the loss if you claim a refund for an earlier year or on a later return where the NOL is used.
18. Rental Losses
These could be challenged if there’s no revenue from the property.
19. Hobby Losses
Multi-year losses on Schedule C (or a pass-through entity such as an S corporation) may be scrutinized, particularly if the business is listed as one that has elements of personal pleasure, such as horse breeding, photography, or auto racing. Your audit chances increase if the losses offset substantial other income on the return.
If you file a business return, there are other triggers. Some of them also apply to rental properties.
20. Travel and Entertainment
Because of the recordkeeping requirements, and the fact that some deductions can be questionable, this is a ripe area for the IRS.
21. Auto Usage
The IRS is aware that many taxpayers fail to keep the required records, making this a fruitful area for an IRS adjustment during an audit.
22. Repairs and Maintenance
What business property owners believe is a repair and what the tax law considers a repair is often different. The IRS may require you to capitalize and depreciate expenses that you deducted.
23. Zero Officer Salaries for an S Corporation
If an S corporation is active, showing no salary for officers is a red flag.
These are only some of the items that can trigger an audit. What should you do if you have them on your return? If you’re entitled to tax breaks, it doesn’t make sense not to claim them. Just make sure you have the required records and tax law justification to back them up. For example, if you’re not sure if a part business / part personal trip is deductible, ask your tax advisor for a professional opinion.
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