When you get ready to prepare your taxes, you may be concerned about making a mistake or doing anything else that could trigger an IRS tax audit.
While audits are perhaps less common than they were in prior years, the IRS continues to select tax returns each year for additional scrutiny and review. In many cases, returns selected for audits are chosen by a computer algorithm.
In 2017, slightly over 1 million returns were selected for audit – out of around 140 million total taxpayers. Here are a few common IRS tax audit triggers for you to watch for when preparing your annual tax return.
You Didn’t Report All Your Income
Under tax law, companies and individuals that hire you must report your pay both to you and to the IRS. Therefore, the IRS receives copies of all of the W-2 and 1099-MISC forms filed by companies for employment and freelance work, as well as 1099s for interest and dividend income. These are tied to your Social Security number. If you don’t report all of the income the IRS already knows that you have, this could show up as a clear discrepancy in the IRS’ automated system.
You Have Very High or Very Low Income
In general, the IRS is more interested in auditing higher-income taxpayers. The IRS is looking for a higher likelihood of unpaid taxes as well as a greater chance to actually collect the money that is owed.
When people earn more than $1 million each year, the likelihood of being audited rises substantially. In most cases, people with high incomes often have multiple sources of income and more complex returns, making a number of audit triggers more likely. Perhaps unexpectedly, people with very low incomes are also more likely to be audited. Here, the IRS is more interested in questionable tax credit claims or excessive deductions used to lower an originally higher income.
You Itemize Your Deductions
Most people take the standard deduction on their tax returns, especially after the passage of the Tax Cuts and Jobs Act in 2017 that made itemizing less accessible. However, itemized deductions are important for many people, especially those with complex tax returns and small businesses. If you claim large charitable deductions, the IRS may want proof of those donations. They do not expect that people will grant large percentages of their income to charity each year, so the IRS may be skeptical about large donation claims.
You Run a Cash Business
If you make large transactions of $10,000 or more in cash, the business on the other side may be required to report them to the IRS, even if you are just making a purchase. The same is true if you make large cash deposits in your bank account. These large cash transactions may raise questions for the tax agency, especially if you generally report a lower income. If you use a Schedule C when filing your taxes and report mostly cash income and losses, the IRS may have extra scrutiny to see if you are overstating your expenses.
You Deduct Entertainment Expenses
Self-employed taxpayers are always at greater risk of an audit, simply because of the greater flexibility that you have in reporting your income and expenses for the year. Some types of claims draw more scrutiny, however, including deductions for business travel, meals and entertainment.
If you are an employee who was already reimbursed by your company, you can’t claim these costs on your taxes as well. If you are a business owner, make sure to keep your documentation of these expenses, including the business purpose involved.
You Claim Home Office Expenses
There are very specific rules for home office deductions for people who run their businesses out of their homes. If you are going to deduct home office expenses, you must claim only the space that is used solely for business. Many people try to claim multi-purpose areas for a home office deduction, however. Make sure that you’re following the rules when it comes to claiming your home office space.
You Have International Assets
In general, foreign bank accounts will be reported to the IRS. If you have more than $10,000 in overseas bank accounts, you must report those balances to FinCEN, while accounts with $50,000 or more must be reported to the IRS. While the tax agency isn’t all that interested in small accounts held by people living overseas, it is definitely interested in cracking down on tax evasion and avoidance in offshore accounts.
You Use Your Car For Business
Similar to home office expenses, there are regulations about how you report vehicle and mileage expenses. If you own one car, it is highly unusual that you will use this car for business only. If you claim that your vehicle is used 100% of the time for business, this is likely to draw questions from the IRS, especially if you do not have another personal car. Make sure to keep records if you are claiming a high percentage of business use for your vehicle.
You Made a Retirement Withdrawal
If you’re not yet at retirement age but you make a withdrawal or take a loan from your 401(k) or IRA, you may be subject to a tax penalty. There’s nothing wrong with taking an early withdrawal, but you have to report it properly to the IRS. According to the agency, up to 40% of people misstate their retirement fund withdrawals on their tax returns. If you’re under 59 1/2, you’ll likely have to pay a tax penalty of 10%, although there are some exceptions.
You Have a Small, Hobby Business
Having a small business can open up an array of additional tax deductions. However, many people have hobbies that might bring in some income from time to time but also carry substantial expenses. In general, the IRS expects that you will make a profit from your small business for three out of every five tax years of operation. Hobby activities do not have the same entitlement to tax deductions as businesses, so be careful about deductions for small side gigs.
You File For the Earned Income Tax Credit (EITC)
The Earned Income Tax Credit (EITC) is an important credit for many lower-income taxpayers, and the amount to which you are entitled grows along with the number of dependents you have. Because this is a refundable credit, you can receive a check from the IRS if you have a tax overpayment with the EITC in mind. This means that EITC claims are more likely to be subject to an audit, especially as the IRS claims it has paid out billions in erroneous refunds.
You Made Some Math Mistakes
Math mistakes are generally not too important. In most cases, tax audits are not linked to mathematical errors but instead reflect a disparity that significantly reduces your tax burden. Nevertheless, working with a professional accountant or online tax preparation system to avoid errors is always a good bet to stay on the safe side.
You Triggered the Algorithm
The IRS processes so many returns each year that most disparities are flagged by the tax agency’s algorithm, rather than by human eyes. The computer system that processes returns is programmed to look for certain types of unusual claims, large deductions, shared dependents and other questionable items.
No one wants to go through an IRS tax audit. One way to protect yourself, especially if you have a complex return, is to work with a tax professional who knows the rules and can make sure to avoid errors and mistakes. At Picnic Tax, we connect you directly with specially screened online accountants who can help you to maximize your tax refund while staying within the IRS’ rules. Contact us to find out more about our services today.