No one wants to create tax return red flags that would make the IRS scrutinize their small business or personal income tax return. However tax time can be one of the most stressful times of the year due to that fear. Just preparing the forms is hard enough. But actually owing the government money can escalate those stressful feelings into downright panic. However nothing compares to how you feel when you first learn that your taxes are about to be audited.
The truth is that audits are relatively rare in the United States. The IRS reports that between 2010 and 2018 only 0.6% of individual tax returns resulted in an audit. That may make you feel better, but statistically speaking it’s still high. More than 250,000 taxpayers had to go through the process. In many cases, had the taxpayers simply known what to avoid, the audit process could have been avoided completely. That is what this article is all about. We want to share the specific triggers that send up IRS red flags and frequently lead to an audit so it won’t happen to you.
Common Tax Return Red Flags Include the Following Issues
Disparities Between Information on Tax Forms and Reported Income
Whether you’re a W-2 employee or self-employed, the IRS will compare the income information. The IRS compares what you report on your tax forms with the forms sent in by the entities that paid you. If the two don’t match, the IRS is going to want to know why.
Disparities Between Business Income and Business Expenses
Just as the IRS will respond when your tax form income and reported income don’t match, the same occurs for businesses that report expenses that don’t make sense. In some cases, they are looking for people who are trying to take business expense deductions for what is really a hobby rather than a business.
Many times these disparities are the result of actual expenses incurred for which income went unreported. Though there is always the chance that the odd numbers are accidental, that’s not often the case. For example, the result of duplication of employee and business expenses. That type of oversight can lead to an audit. So take the time to double and triple check before filing your tax forms.
Contributions and Deduction Triggers
Outsized Charitable Contributions
Our tax system awards charitable contributions with tax deductions. While that is a powerful incentive for some, it has also served as a temptation for others. To counter this, the IRS has created an automated computer program that analyzes returns to identify “triggers”. These triggers are figures that seem outsized as compared to an individual’s income, and other commonly abused factors. The system assesses each return and assigns a DIF, or Discriminate Function, score. If your return exceeds the IRS DIF score threshold, there’s a good chance you’re headed for an audit.
Disproportionate Itemized Deductions
If you qualify to itemize, then you’re entitled to take deductions for qualifying expenses. But in cases where itemized deductions seem disproportionately high, the IRS is likely to ask some questions. If the expenses are legitimate and you’re able to present documentation, you’ll be fine. However retain your receipts, as there’s a good chance that you’ll be called in for an audit.
Additional Tax Return Red Flags Show These Issues
Disparities Between Lifestyle Expenses and Reported Income
The IRS is particularly sensitive to returns in which taxpayers take deductions for expenses that are out of proportion to their income. For example, paying personal property taxes and taking mortgage interest deductions for a million-dollar lifestyle will raise a red flag. Particularly if the income you’re reporting is not enough to support it.
When You Happen to Hit Right on the Income to Expense Ratio You Need to Qualify for the Earned Income Credit
To claim the Earned Income Credit taxpayers’ income has to be below a certain level. (The EIC can be as high as $6,660 for tax year 2020). As a business owner whose return includes a Schedule C, there’s a ratio that you need to achieve in order to qualify. In most cases a business will either be somewhere below the ratio or above the ratio. That is, they’ll either qualify for a larger earned income credit or they won’t. If the number hits exactly at the level needed to qualify for the larger credit, the IRS is more likely to scrutinize the results. They will want a closer look to see if numbers on either side of the equation have been manipulated.
One Important Thing to Remember about Tax Return Red Flags
You may have been able to deduct unreimbursed employee business expenses in the past. But that stopped being true for federal income taxes after tax year 2017. Some states (including California, still permit those deductions on state taxes. Just make sure that you maintain receipts for those returns as well.
Bitcoin
Lapses in Reporting Cryptocurrency Transactions
Bitcoin and other virtual currency transactions have led to plenty of tax return headaches. In the last several years, approximately 10,000 taxpayers have failed to report gains or losses on this innovative currency. To address the bitcoin issue, the IRS now sends certain taxpayers letters. The letters provide a chance to take part in a voluntary disclosure program regarding bitcoin. The agency is clearly on the watch for and acting upon this particular tax return red flag.
In addition to the letters, the IRS has added a question to the 1040. The question added is: “Did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” Of course, if you answer no and later it is determined you did, then you have committed perjury. An universal No No. This could trigger both an audit, and legal action against you, as you sign your return under penalty of perjury.
Rentals
Rental Property Expenses that Appear to be Inflated
One of the most common reasons for tax returns to be flagged is rental expenses that appear to be inflated. Taxpayers who prepare their own returns and who report deductions for rental income on their Schedule E need to ensure that they fully understand that some deductions are allowed and some need to be capitalized over time. Not having a full understanding of how this works could lead to a return being flagged. There are also special and rather complicated rules associated with renting a vacation home, room rentals and short-term rentals.
Common Tax return red flags for Parents and Married People
Two People Claiming the Same Dependent
It’s very common for families that split custody, to alternate the years in which they claim the dependent. Usually this happens as a result of separation or divorce. However, if mistakes – or fraud – are detected with both taxpayers claiming the same individual, that will trigger an audit. Proving custody will require documentation, including school records and birth certificates.
Not Understanding Which Filing Status to Use
Though the head of household filing status is extremely useful, it can also be confusing and lead to mistakes when filling out status, and especially regarding how dependents are treated. Though the Tax Cuts and Jobs Act of 2017 was supposed to simplify the tax form process, in this particular area it made things even more complicated by introducing a new $500 credit for ‘qualifying relatives’, which is defined by certain tests that may make people not related to the taxpayer eligible as a dependent while not making the taxpayer eligible for the head of household filing status.
Unreported Foreign Financial Accounts are Tax Return Red Flags
Failure to Report Overseas Accounts
Whether it generates taxable income or not, if you are a U.S. citizen or U.S. resident with interest in, authority over, or signature authority on foreign financial accounts that exceed $10,000 at any time during the calendar year, you are required to report them to the U.S. Treasury Department under the Bank Secrecy Act. The appropriate form to file, is the Report of Foreign Bank and Financial Accounts, or FBAR. Failing to disclose these accounts is risky. Due to disclosure requirements placed on foreign financial institutions, discovery is common. And worse, the deception can have significant repercussions.
In Case of Audit
The goal of providing this information is to fend off the possibility of red flags ever being raised on your tax filing. However, if one of those envelopes with the IRS return address appears in your mailbox, contact us immediately.
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