It’s true that the majority of tax returns will never have to undergo an audit; however, for the unlucky few taxpayers who submit legitimate tax returns and still must endure an audit, even one audit experience is one too many. Here are five types of red flags that are more likely to make the IRS look twice at your return in 2020, and how to avoid grabbing too much attention.
Did you know that out of all the audits flagged for potential fraud in 2018, an average of 72 percent was legitimate?
Taking Excessive Deductions
One of the biggest red flags for the IRS is taking overly excessive tax deductions. Charitable donations and the home office deduction are common culprits where taxpayers may try to fudge the numbers or report unsubstantiated amounts.
This ties in with another common red flag, which is covered next.
Owning a Business
Unfortunately, the IRS tends to target sole proprietorships and cash-intensive businesses more carefully than typical tax returns. It’s due to the amount of lost tax revenue from so many business owners filing excessive deductions on the Schedule C. Even if your business isn’t structured as a sole proprietorship, make sure you keep adequate records for anything you claim; that way, if the IRS does flag your return, you have the paper trail to back it up.
Especially since the Meals & Entertainment business deductions changed since the Tax Cuts and Jobs Act was introduced, the IRS is more likely than ever to scrutinize these types of deductions. Make sure the receipts clearly document the date and purpose for the business meeting, and that the expenses are properly coded in your Chart of Accounts.
Making a Lot of Money
Kiplinger estimates that the typical average for IRS audits are one in 170 returns. High-income earners with more than $1 million in adjusted gross income will have a much higher chance of being audited – to the tune of one in 30. If you’re part of the million-dollar club, ensure your deductions and credits aren’t exaggerated and can be fully substantiated with receipts and reports.
Not Reporting All Income
Self-employed taxpayers and those who earn multiple types of income will have 1099s on file with the IRS. Sometimes, your reported income can be different, especially if you earned income throughout the year that was less than the $600 threshold required for filing a 1099. While the IRS will go by your reported income by default, especially if you’re reporting more than 1099 income, you can still expect them to double check when the two amounts don’t equal each other. It’s a good idea to check yourself that all 1099 income matches what you received, and if it’s incorrect, request an amended form.
Holding Investments or Assets in Foreign Accounts
The IRS is more likely to review tax returns with reported assets in other countries, especially those with more favorable tax laws than the U.S. Use FinCEN Form 114 to report foreign account balances of $10,000 or more and Form 8938 to report account balances of $50,000 or more. Of course, it is wise to report all assets, even those less than $10,000. Work with your CPA to manage your tax exposure here.
Multiple years of hobby losses, reporting excessive losses from a rental property, making large cash deposits (especially without reporting that income, such as from gambling winnings), are also red flags you should try to avoid. There are other scenarios that will cause the IRS to look twice at your return, so if you have any questions, contact a tax professional.
Working with a CPA who understands your industry and your family’s tax goals can help alleviate many of these issues. If you’d like a second opinion from Naden/Lean, or a review of prior year tax returns, contact us today.