Authored By: Sheri Lewis, Staff Accountant, who has worked at Cook Martin Poulson since November 2011. She recently received her Master of Accounting Degree and is in the process of taking the CPA exams.
Although the IRS will audit less than an estimated of 1% of all the individual tax returns each year, the chance of being audited is a common fear of many clients. While no one can predict with certainty who will be audited, there are some common “red flags” that could increase your chance of audit. The IRS won’t come right out and provide a list of items they consider for audit, but there have been recent articles by tax professionals that outline some key areas that past data has shown to have been more heavily scrutinized by the IRS.
Some of the common “red flags” are as follows:
1. Having a large income or not reporting all of your income. The IRS receives copies of all your W2s and 1099 forms. If the amounts don’t match up, the IRS will want to know why. Additionally, the odds of audit increase as your income goes up. Those reporting $1 million or more of income have a greater likelihood at being looked at more carefully by the IRS.
2. Reporting an inordinately large amount of charitable contributions. The IRS has calculated the average amount of charitable contributions based on income level and compares these amounts with what you have reported. Also, any non-cash donations over $500 require an appraisal or documentation showing how the value was determined. The key is to have proper documentation substantiating your donations.
3. Operating a small business and filing a Schedule C to report your income and expenses. Several factors play into this area. Running a small business that is “cash” concentrated has a higher audit risk due to the greater chance of not reporting all of your income. Also, the higher the amount of income and expense, the greater the chance of audit. Big deductions for business meals, travel, and entertainment could raise the eyebrows of IRS agents.
4. Claiming 100% use of a vehicle for business and/or claiming an unusually large amount of auto expenses. It is rare for a small business owner to use a vehicle 100% of the time for business. In case of audit, be sure to keep detailed mileage logs including dates and business purposes. You can use the standard mileage rate or depreciate the vehicle and claim the costs associated with operating the vehicle. Once you choose a method, you have to keep using it.
5. Claiming a “hefty” home office deduction. In order to take the home office deduction (taking a percentage of housing costs) the space must be used “exclusively” and “on a regular basis” as the principal place for conducting business. The space can’t be used for activities that normally occur in your house such as watching TV, doing homework, or serving as a playroom or guest bedroom.
6. Not reporting a foreign bank account. If you have money in foreign accounts that in aggregate total more than $10,000 at any time during the previous tax year, you must report these accounts by filing Form 114.
7. Taking itemized deductions that are viewed by the IRS as above average. The IRS will compare your income to your deductions to see if the deductions suggest an improper balance.
8. Improper reporting of rental activity losses. In order for real estate professionals to claim rental losses, stringent parameters must be met. Also, if you actively participated in the renting property that you own, you can deduct up to $25,000 of loss against your income. But this also has certain requirements and begins to phase out when your AGI reaches $100,000.
While no one knows for sure what will trigger an audit, having proper documentation and discussing your financial transactions with your CPA can help make an audit a little more tolerable.
14 IRS Audit Red Flags by Joy Taylor, Updated Feb 2014, Kiplinger Tax Letter
Accounting Today Feb 13, 2014, Talk to Your Clients about Audits by Roger Russell
Fox Business published Feb 18, 2014, 6 Reasons Your Tax Return Might Get Audited by Kathryn Buschman Vasel