Although the chances of being audited are relatively rare, certain items on a taxpayer’s tax return stand out as “red flags” to the IRS agents responsible for selecting returns to audit. If you have any of these items on your tax return, you are at an increased risk for a tax audit because these “red flags” are used as audit triggers.
1. IRS Audit Red Flag: Not Reporting All Your Income
If you work for an employer who provides you with a W-9 form, the IRS also receives a copy of that form. The IRS also receives copies of any 1099s you may receive from working as an independent contractor. Thus, if you attempt to underreport these figures on your tax return, the IRS will be able to notice that difference, and your tax return will be potentially flagged for audit.
2. Earning a High Income
Only 1% of the population will generally be audited each year. However, statistics from 2012 and earlier years demonstrate that higher earners are more likely to be audited than those with lower incomes. In 2012, taxpayers earning more than $200,000 per year had an audit rate of approximately 4%. For taxpayers whose income is over $5 million, that percentage increases to 21% and 30% for taxpayers earning more than $10 million.
3. Failing to Report a Foreign Bank Account
In recent years, the IRS has increased scrutiny on taxpayers who have foreign bank accounts and assets. The IRS has a voluntary disclosure policy with respect to foreign bank accounts. Any taxpayer with a foreign bank account containing more than $10,000 over the course of the tax year is required to report to the IRS. In fact, the IRS has apparently made punishing those who fail to disclose the existence of foreign bank accounts and assets a top priority. Finally, if you indicate on your return that you do business in foreign countries or take many trips abroad for work, but fail to report any foreign assets, that can raise red flags and increase your chance of being selected for an IRS audit.
4. Taking Large Charitable Contributions
The IRS is very sophisticated and it knows that taxpayers at certain income letters typically contribute a certain amount to charities for the year. Thus, when the charitable deductions you claim are disproportionately large compared to your income that typically raises a red flag with the IRS. This essentially means that if you report high charitable deductions, you should make sure that you have the required documentation to back up those figures.
5. Claiming the Home Office Deduction
Claiming a home office deduction is a red flag for the IRS and taxpayers who do so have a higher likelihood of being selected for an audit. In order to lawfully take advantage of the home office deduction, you must have a home office space which you use exclusively and regularly as your principal place of business. In order to avoid being audited, make sure you claim reasonable expenses. You should also only claim those expenses that directly apply to the part of the home used as an office.
6. Claiming 100% Business Use of a Vehicle
If you claim 100% business use of a vehicle, you are more likely to be audited. This raises red flags for the IRS because the IRS knows that it is extremely rare for an individual taxpayer to use a vehicle 100% of the time for business use. To avoid raising a red flag on this issue, you should use Form 4562 to show only the percentage your vehicle was used for business purposes during the year. In case you get audited, you should also keep a detailed mileage log and calendar entries listing the purpose of every road trip taken.
7. Running a Cash Business
The IRS often targets small business owners whose business is primarily cash-based, such as taxis, car washes, bars, and other businesses. Owners of these small cash-based businesses often fail to accurately report all their taxable income, making the IRS much more interested in their tax returns.
8. Taking Higher than Average Deductions
You are more likely to be audited if the deductions on your return are disproportionately large compared to your income. It is wise to make sure that your deductions are reasonable in light of your taxable income as a whole. However, if you have the documentation necessary to support the deduction, you will be able to demonstrate your entitlement to the deduction in case an audit occurs.
9. Deducting Business Meals, Travel, and Entertainment
One of the biggest red flags for an IRS auditor is a tax return in which the taxpayer claims large deductions for business meals, travel and entertainment. The deductions for meals, travel, and entertainment come with strict rules regarding substantiation, and the IRS is keenly aware of tax returns that do not meet these rules. In order to qualify for large business meals, travel, and entertainment deductions, you must keep detailed records. These records must contain information about the date, location, and business purpose of the expenditure. In addition, if you are claiming a deduction for lodging, you must keep records for any expenditure of more than $75. If you do not have this required documentation, your tax return will be flagged and your chances of being selected for an audit increase.
10. Claiming Rental Losses
The IRS auditors are very suspicious of taxpayers who claim large rental losses, especially when claimed by self-proclaimed real estate experts or taxpayers whose W-2 forms show large income. The IRS formed a real estate professional audit project only several years ago, but it has resulted in a significant number of taxpayers being audited. In order to satisfy the rules of claiming rental losses without limitation, you must spend more than 50% of your working hours and more than 750 hours each year materially participating in real estate as a developer, broker, or landlord.
However, if you actively participate in the renting of your own property, you can deduct up to $25,000 of loss against your other income. This $25,000 allowance phases out as adjusted gross income exceeds $100,000 and disappears entirely once your AGI reaches $150,000.