Chief Tax Information Officer
Published on: March 04, 2021
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Two words that make every taxpayer nervous: IRS audit. No matter who you are, there’s probably a small piece of you that fears an IRS audit.
While the IRS doesn’t have an exact science or formula of which taxpayers will get audited, there are some common items that raise red flags within the IRS systems. These are potential signs that a tax return may require additional information to verify the accuracy of the tax return.
Taxpayers should not live in fear because few people are at risk of an IRS audit. According to IRS data from 2015, 1% of taxpayers making between $200,000 and $1,000,000 are at risk of an IRS audit. While taxpayers who make more than $1,000,000, have a 2.6% chance of an IRS audit and those who made under $200,000 have less than 1% chance of an IRS audit.
However, it’s still important to know the most common red flags that may trigger an IRS audit.
The most common item that might flag the IRS is mismatched information; meaning any information that doesn’t match between your tax return and the IRS system. This can be anything from names and Social Security numbers not matching to capital gains or losses, leaving off a W-2, or leaving off income -- any form of income for that matter, including IRS paid interest, dividends and especially virtual currency activity if you have it.
Remember there is no $600 rule, no $400 rule, no $10 rule, not even a $5 rule, the minimum amount to report is $1. The IRS receives income information about you from third parties, including employers, investment firms, and others. By cross referencing your return with these third-party sources the IRS can identify whether you earned money that you did not report on your taxes.
The IRS knows what the average charitable income is per tax bracket, so if your charitable donations are higher than average you’ll stand out. That paired with a lack of proper documentation (receipts, IRS Form 8283, or appraisals for donations of property) can be a red flag for the IRS. Don’t be afraid to claim your charitable contributions, just be sure that when you do you include the necessary documentation.
Additionally, because of the CARES Act, every tax return can claim up to $300 in cash charitable donations when they claim the standard deduction. Taxpayers don’t need to itemize this year to claim a charitable donation.
Having foreign assets or cash is a major red flag for the IRS, especially if the nation in question is one that has tax laws which are much more lenient than the US. Of late, the IRS has been strictly monitoring such tax returns. You must report all foreign accounts that you hold with a total cumulative balance exceeding $10,000. In most cases, the IRS can seek information about your account from the foreign bank.
Big deductions on a tax return – no matter what they are can also flag the IRS that there’s something wonky with a return. Whether the deduction is a charitable donation, a medical expense, or a gambling loss -- if it’s large, the IRS might take a closer look. So, it’s important to keep good, accurate records for support with any large deductions and credits you feel you’re eligible for.
Claiming an excessive number of credits or some of the larger tax credits can also be a red flag for the IRS – in particular when compared with OTHER data on your tax return.
Meals and travel are common deductions taken on Schedule C by many business owners. If these write-offs are large, that could be a red flag to the IRS.
The IRS is on the lookout for meals or travel deductions that don’t satisfy the strict substantiation rules. Be sure to keep all receipts and documentation for these deductions and any others. Information such as the purchase price, place of purchase, business purpose, and nature of the meeting/travel. Additionally, the 2017 tax reform law (The Tax Cuts and Jobs Act) eliminated the deduction of entertainment expenses. This means that sports tickets, golfing, and other entertainment expenses are no longer deductible.
Another red flag is continuous business losses year over year or reporting a large capital loss – really anything that triggers deductible losses year after year, thereby reducing taxes can be seen as a red flag. The IRS rules allow a Schedule C loss for two out of any five years and a Farming loss for two out of any five years. They are also looking for a business plan and will work with you if these losses are normal in your area, for your business, and based on the current economy. Once again, if you had a business, make sure you keep good records.
Depreciating your vehicle can be a red flag if you claim the vehicle is 100% business use. It’s rare for a vehicle to be 100% business use and the IRS is particularly suspicious of individuals who don’t appear to have another vehicle available for personal use. If you do claim a vehicle for 100% business use, be sure to keep detailed mileage records and calendar entries for dates and purposes used, and you better have a second vehicle for personal purposes.
In 2020, more people than ever worked from home. So, it might be tempting to claim your home office as a deduction on your taxes. However, only a select few individuals qualify. In order to claim your home office on your taxes, you need to be self-employed such as an independent contractor -- you can’t take the deduction if you are a W-2 employee and happen to be working from home.
If you are self-employed, you can get the deduction by:
The IRS is actively looking at individuals who sell, trade, receive or otherwise deal in cryptocurrencies. The IRS aims to crack down on unreported income stemming from these transactions and are investing a lot of effort and resources to do so. In fact, page one of the 2020 Form 1040 asks specifically if you have received, sold, traded, exchanged or acquired any virtual currency in the last year.
The IRS has teams dedicated to cryptocurrency-related audits and have even gone to federal court to get the names of users with Coinbase accounts. The IRS has a dedicated FAQ page to help individuals who seek to deal in virtual currencies do so in compliance with the law.
Finally, it is your responsibility as a taxpayer to prove your income, deductions, and credits you have claimed on your tax return. It’s important, more than ever, to make sure that your records are up-to-date and match what employers, State agencies, and others will also submit to the IRS. Schedule an appointment today with a nearby Tax Pro to ensure you don’t risk getting an audit.
About the Author
Mark Steber is Senior Vice President and Chief Tax Information Officer for Jackson Hewitt. With over 30 years of experience, he oversees tax service delivery, quality assurance and tax law adherence. Mark is Jackson Hewitt’s national spokesperson and liaison to the Internal Revenue Service and other government authorities. He is a Certified Public Accountant (CPA), holds registrations in Alabama and Georgia, and is an expert on consumer income taxes including electronic tax and tax data protection.