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Tax Day 2021 is still months away, but now’s the time to begin preparing for filing your taxes. Keep in mind that audits happen. What’s more, your last three tax returns are subject to scrutiny.
What is an IRS Audit?
An IRS audit is an official review by the Internal Revenue Service of a business’ or individual’s tax return, supporting documents and other financial accounts and information to ensure the accuracy of the information reported on the return, including the amount of income reported.
The percentage of individual tax returns that are selected for an IRS audit is relatively small. In 2018, just 0.63% of individual tax returns were selected for audits, or fewer than one out of every 100 returns. This is down from 1.11% of individual tax returns that were selected for audits in 2010.
Top IRS Audit Triggers
But just because the odds of being audited are small doesn’t mean that it’s impossible for you to be audited by the IRS. To prevent fraud, the IRS continues to increase their usage of automated programs to identify tax returns that they believe warrant further scrutiny.
To reduce the chances that your tax return is audited, you should be aware of certain things that tend to be flag returns for the IRS. Here are 12 IRS audit triggers to be aware of:
Math Errors and Typos
The IRS has programs that check the math and calculations on tax returns. If your return “doesn’t add up,” it may be flagged for further review. Double check your social security numbers – and your math.
Fewer than 1% of tax returns with $200,000 or less in income are audited. That percentage grows to 10% and higher for those earning above $1 million. Obviously, you don’t want to try to earn less money to avoid an audit! As you’d expect, the higher your income, the more likely you will get attention from the IRS.
The IRS receives copies of your W-2s and 1099s, and their systems automatically compare this data to the amounts you report on your tax return. A discrepancy, such as a 1099 that isn’t reported on your return, could trigger further review. So, if you receive a 1099 that isn’t yours, or isn’t correct, don’t ignore it. Contact the issuer of that 1099 and ask them to report a corrected form to the IRS.
The IRS will compare your itemized deductions to the average total deductions for a given item claimed by other taxpayers who are in the same income range as you. A taxpayer whose deductions appear to exceed these averages may be further scrutinized by the IRS. Don’t hesitate to claim every deduction that you are entitled to – just make sure you have the proper documentation.
Schedule C Filers
The IRS particularly watches for businesses that operate primarily with cash – and almost certainly those that are reporting a loss. They have lots of experience auditing self-employed taxpayers who underreport income or overstate expenses. Just make sure your records support what you are reporting.
Claiming 100% Business Use of a Vehicle
The IRS knows that it’s rare for someone to use a vehicle they own 100% of the time for business purposes. And, if you don’t have another personal vehicle registered in your name, it’s nearly impossible to report that the vehicle is exclusively used for business. Claiming 100% business use of a vehicle will almost certainly draw IRS attention. The higher percentage you are claiming, the more critical it is that you have detailed records.
Claiming a Loss on a Hobby
Writing off expenses for a business is fine – but you can’t portray your hobby as a business. For it to be a business, you must have a reasonable expectation to make a profit. In general, the IRS will expect you to report a profit for 3 of every 5 years you operate the business. If you report your hobby as a business, it must be run like a business, with appropriate records and documentation. Otherwise, the IRS could require you to restate any business income/loss as a hobby income/loss, subject to hobby rules. For more information, refer to the IRS’s rules on hobbies.
Home Office Deduction
To claim the Home Office Deduction, you must use a portion of your home “regularly and exclusively” for business. Keep in mind that the IRS doesn’t see the dining room table as a desk! And having a TV in the “home office” could raise exclusivity questions. Most importantly, home office deductions from a person earning wages may draw increased attention, so make sure home office expenses are well-documented and supported.
Deducting Business Meals, Travel and Entertainment
This is another area that draws IRS attention because of past abuse. First, it’s probably obvious that you can’t deduct expenses for which your employer reimburses you. Second, you must keep careful records – not just a receipt, but also a record of who was in attendance and the specific business purpose. The IRS doesn’t want you enjoying lavish meals and entertainment on Uncle Sam’s nickel.
Earned Income Tax Credit (EITC)
The IRS estimates that billions of dollars of EITC claims are paid in error. Some errors are unintentional, but the IRS scrutinizes EITC claims closely to prevent fraud. If you claim the Earned Income Tax Credit, make sure to document how you meet EITC rules so that you can provide this documentation to the IRS in the future, if needed.
Dealing in Cryptocurrency and Other Virtual Currency
There’s less government regulation over cryptocurrencies like Bitcoin and Ethereum than over regular currency, which opens the door to potential fraud opportunities. The IRS has created a compliance campaign that’s focused exclusively on cryptocurrency transactions and also beefed up enforcement to address abuse of virtual currencies.
Taking Early Withdrawals from Retirement Accounts
These withdrawals must meet certain criteria in order to avoid taxation and penalties. Therefore, the IRS keeps an eye out for unreported early retirement account withdrawals that don’t meet the criteria and are therefore taxable.
How Far Back Can the IRS Audit?
In normal circumstances, the IRS is allowed by law to go back three years when auditing tax returns. However, if errors are detected in a return, they can go back even further, though they usually don’t go back more than six years.
The IRS has up to three years to assess additional taxes after conducting an audit, though they can request an extension to this. (You are not legally required to accept the extension.) And they have three years after the audit to issue a refund if one is due to you.
How Long Should You Keep Tax Records?
Since the IRS is normally allowed to audit the past three years’ tax returns, you should keep all tax returns and records for at least three years. Some experts recommend keeping tax returns for up to six or seven years in case the IRS goes back further than three years when conducting an audit.
Keep in mind that if you fail to file a tax return, the IRS can conduct audits going back indefinitely.
What Should You Do If You’re Audited?
So what should you do if you receive a notice from the IRS that your tax return is being audited? The most important thing is to respond to all IRS requests promptly and in a friendly and cooperative manner.
Often the audit can be handled by mail and you won’t even have to meet the auditor face to face. This might be the situation, for example, if the IRS is simply requesting documentation to support claims on your return.
Depending on how complex the audit is and how much money is involved, you might want to consult with a tax professional. If an accountant prepared your tax return, you should probably get him or her involved in the audit.
The IRS has created a webpage with lots of practical information to help you prepare for an audit — you can access it here.
Understanding the flags that can trigger an IRS audit is a good way to help you verify that your tax return deductions and claims are accurate and well-documented. Working with a credible CPA, however, is probably your best line of defense when it comes to IRS audits.
Not only will a good CPA be able to help you file your taxes and ensure that these IRS audit triggers are all by the books, but they will also be able to provide detailed documentation and information on your behalf if you should get audited.
The Bottom Line
Preparing for retirement is part of your overall financial plan. You can take a couple of actions now to get yourself on the right track.
Download 5 Tax Hacks for Investors, an actionable guide with insights from fiduciary financial advisors. The guide is free.
Consider talking to a fiduciary financial advisor for more detailed guidance on your tax-optimization strategies.