The Internal Revenue Service (IRS) is responsible for collecting taxes in the United States, and part of their efforts include auditing taxpayers to ensure compliance with tax laws. While audits can be a stressful experience, it’s important to understand that the majority of taxpayers are not audited. According to the most recent data from the IRS, approximately 0.5% of tax returns are audited each year. However, there are certain red flags that could increase your chances of being audited. In this blog post, we’ll explore 8 red flags for IRS audits.
- One of the most common red flags that triggers an IRS audit is omitting income from your tax return. The IRS has a sophisticated document matching system that cross-checks the information on your tax return against data collected from employers, banks, and investment groups. It is essential to include all tax documents received on your tax return to avoid discrepancies. If the IRS finds any unreported income, they will send a notice indicating that your return has been flagged for an audit. Therefore, it is crucial to double-check all your income sources and report them accurately to avoid any potential issues with the IRS.
- The Earned Income Tax Credit (EITC) can provide substantial tax benefits to eligible taxpayers, but the rules surrounding eligibility are quite complex. In fact, the IRS estimates that around 25% of the returns claiming this credit contain errors. Since the EITC amount can be significant and increases with the number of qualifying children, it is a high-risk area for mistakes and errors. As such, taxpayers should take extra care to ensure they meet all the eligibility requirements before claiming this credit on their tax return.
- Working in a cash-heavy business like bars, hair salons, or restaurants can raise red flags for the IRS. Because these businesses deal primarily in cash, there is a temptation for some business owners to underreport their income. The IRS knows this and will be paying close attention to any discrepancies between reported income and actual revenue. If you’re running a cash-heavy business, it’s important to keep detailed records of all your transactions and report all income accurately.
- Rental losses are another red flag that can trigger an IRS audit. While it’s common for rental properties to generate losses in the early years, losses that persist beyond that point can raise suspicions. This is especially true if those losses are not due to depreciation. If you’re claiming rental losses, make sure you can back up your deductions with accurate records and documentation.
- Self-employed taxpayers have a significantly higher likelihood of being audited, with a 300% greater chance than the average taxpayer. This is due to the fact that many self-employed individuals fail to report all of their income, which IRS agents have observed over time. Additionally, self-employed taxpayers are permitted to deduct business expenses from their self-employment income. However, the IRS is aware that some taxpayers may deduct personal or nondeductible expenses or exaggerate expenses on their tax returns. When large cash expenses exceed business income, this raises a red flag, as does reporting losses year after year. Few taxpayers are able to sustain a business loss over multiple years, and this can draw the attention of the IRS.
- With the rise of sharing economy platforms like Airbnb and Uber, more people are earning income from non-traditional sources. However, many of these individuals may not be aware of the tax implications of their earnings, and as a result, may underreport or exclude income altogether. If you’re earning income from the sharing economy, it’s important to understand your reporting obligations and keep accurate records of all transactions.
- Claiming 100% use of a vehicle for business purposes can also be a red flag for the IRS. While it’s certainly possible to use a vehicle exclusively for business purposes, it’s important to keep detailed records of all mileage and expenses. Failing to do so can raise suspicions, particularly if the claimed deductions seem excessive. If you’re claiming business use of a vehicle, make sure you have accurate records to support your deductions.
- Consistently showing losses on your Schedule C can also raise red flags for the IRS. While it’s common for new businesses to generate losses in their early years, if those losses persist over a long period of time, it can call into question whether the business is truly a business, or just a hobby. The IRS has specific rules for distinguishing between a business and a hobby, and if you’re claiming losses, you’ll need to be able to show that you’re operating your business with the intent of making a profit.
So, what can you do to be more prepared and lessen your risk of an IRS audit?
Keep detailed and accurate records: The more organized and detailed your records are, the less likely it is that you will make mistakes or leave out important information. This includes keeping receipts, invoices, and other documents that support your tax return.
Report all income: Make sure you report all income you receive, even if it is not reported to the IRS on a 1099 or W-2 form. The IRS matches all reported income against tax returns, so any discrepancies may trigger an audit.
Be cautious with deductions: Make sure you are eligible to claim any deductions you are taking, and be careful not to inflate or exaggerate them. Large or unusual deductions can raise a red flag with the IRS.
Use a tax professional: Consider using a qualified tax professional to prepare your tax return. They can help you identify deductions and credits you may be eligible for, and can ensure that your return is accurate and complete.