IRS Audit Flags
How To Avoid IRS Audit Flags
- Large changes in income: If you have large swings in your income that aren’t explained with W-2?s or 1099?s, be prepared to explain them.
- Claiming a loss on a small business: Anytime you claim a loss, the IRS is going to take a closer look. If you are audited you will need to show that your business is legitimate and detailed records proving the loss.
- Claiming large charitable contributions: If you are too generous, it’s a red flag for the IRS.
- Claiming a home-office deduction: The IRS knows this is rife with abuse and is on the lookout for people claiming a home office and a salary, or a high home office deduction relative to the business.
- Claiming large business meal & entertainment, auto use deductions: This falls under the same category as the home office deduction.
- Claiming large casualty losses: If you suffered a significant casualty loss and are claiming it on your taxes.
- Claiming rental losses: Like casualty losses, this is another complicated section of the tax code where lots of people slip up. If you otherwise work and are renting out a former residence, you are considered passive and can only deduct a limited amount of your losses ($25,000). Claim more than that and the IRS will want you to prove you were a material participant.
Remember, even if you stay clear of all these, and other, audit red flags, you could still be randomly selected for an audit.
What Is An IRS Audit?
A tax audit is an investigation into the background of tax returns submitted by an individual or business to a tax agency. The idea of a tax audit normally conjures up feelings of anxiety even in persons who believe their tax documents are perfectly in order. While it is true that a tax audit may be called due to some perceived irregularity in one or more returns, it is also true that an audit may be done simply as part of a random sampling.
Why Am I Being Audited?
Nobody can predict with certainty whether a return will be selected for examination. In 2006, they published a page on the IRS.gov website that details exactly how they determined which tax returns to audit. It comes down to these four main ways (for individuals):
- Computer Scoring – Tax returns are “scored” using two systems – Discriminant Function System (DIF) and Unreported Income DIF (UIDIF). The Discriminant Information Function System (DIF) score gives the IRS an indication of the potential for change in taxes due, based on past IRS experience. The Unreported Income DIF (UIDIF), as you can imagine, scores the return on the potential for unreported income. The higher the score, for either, the more likely the return will be reviewed.
- Information Matching – This is an obvious reason because it’s the easiest to catch. The IRS receives the same W-2s and 1099s that you do, so it’s trivial for them to compare the two totals. If they don’t match, they investigate. Usually the investigation is simply a CP2000, rather than a full blown audit, because the problem is easy to catch and correct.
- Related Examinations – Beware who your friends/business contacts are! If their returns are audited and their return includes transactions with you, your return may be audited as well. The reason this makes sense is because if their return has a problem, the correction may involve your return. You may not be audited but you may receive a request for clarification.
- Potential participants in abusive tax avoidance transactions – The IRS may get information about promoters of and participants in various schemes and select a return for audit based on that information.
Most of the red flags you read about fall into one of the first two categories. For example, if you under report your income, you could trigger both the UIDIF score and the information matching reasons.
I’m Being Audited, What Should I Do?
If you receive notice that your return has been selected for examination, contact your income tax professional. If you personally prepared your income tax return, consider contacting a tax professional. IRS notices are pretty specific regarding which items they wish to look at, but will request access to virtually all of your accounting records for the period in question. On-site audits can range anywhere from a couple hours to several days. Once the IRS begins their investigation, they can expand the scope of the audit to include other deductions or tax years if the initial investigation leads them to believe more tax revenue will result from those efforts.
How to Prepare for an Audit
In spite of your best efforts, you might still be audited. The statute of limitations is three years for an audit, but if the IRS suspects tax fraud it is extended to seven years. In most cases, resolving the issue is simply a matter of providing the IRS with the documentation to back up what’s in your return, whether it is a receipt, interest statement, mileage log or some other form of documentation. Make sure you keep good records, and store supporting documents and information with each year’s tax return.