Best Audit Triggers To Catch The Attention Of IRS

It can be difficult to prepare a tax return and, as a result, to be concerned about an IRS audit. However, it would be best if you were encouraged because full-fledged tax audits are uncommon. Due to federal budget constraints that have reduced employee size, the IRS has audited fewer returns since 2010. In 2019 (the most recent data available), only 0.25 percent of all individual returns were reviewed, down from 0.9 percent in 2010. However, taxpayers frequently make a few errors that raise the likelihood of a second examination of their returns by an agent.

The Trigger of the Computer

The Internal Revenue Service (IRS) uses a computer system called Discriminant Information Function (DIF) to detect irregularities in tax returns. Every tax return that the IRS receives is scanned. DIF checks for things like duplicate information—for example, if two or more people claimed the same dependent—and deductions and credits that aren't appropriate for the taxpayer. Each return is compared to those of other taxpayers who earned roughly the same amount. Most people who earn $40,000 a year don't donate $30,000 to charity and get a tax deduction. Thus DIF is almost certain to raise the alarm if you do. If DIF flags something, it will be reviewed by a human agent immediately. You can make a lot of money...or very little money. The IRS will not conduct an audit unless agents are reasonably certain that the taxpayer owes additional taxes and that the IRS has a good likelihood of collecting those funds. This focuses on high-earning individuals. The vast majority of audited returns are for taxpayers with annual incomes of $500,000 or more, with the majority exceeding $1 million. These are the only salary groups with a greater than 1% chance of being audited in recent years. According to IRS figures, you're safer if your income ranges from $25,000 to less than $500,000. In 2019, these taxpayers were audited the least. 1

You Forgot About Earnings

Your company must issue a W-2 and send a copy to the IRS for your wages. If a payor pays $600 or more in a year to an independent contractor or freelancer for services, the IRS requires that Form 1099 information returns be made. If you have an interest or dividend income, you will receive a Form 1099-INT or 1099-DIV at the end of the year, and yes, the IRS will receive a copy. If you win big at the casino or the lottery, you should expect a Form W-2G from you and the agency. All of these information forms are put into DIF, so if you don't include any of these sources of income on your tax return, you'll get a red signal Except for a few exceptions, all income you receive is taxable and must be reported, including tips, cash for services, and income less than $600, and does not require Form 1099-MISC. You must still pay taxes on it. 5

You have a large sum of money that you have spent or deposited.

Various businesses are obligated to alert the IRS and other government agencies anytime someone engages in substantial cash transactions involving more than $10,000 under the Bank Secrecy Act. The goal is to prevent illicit activity. 6 If you put down or deposit a large sum of money for whatever reason, the IRS is likely to wonder where it came from, especially if your claimed income doesn't support it. If you make a big deposit exceeding $10,000, the IRS will be notified. If you file a tax return, you'll have to explain how and why you got the money. It isn't necessary to make a lump-sum payment. If you make two or more transactions that are less than $1,000 but sum up to more than the threshold, the IRS claims you're "structuring" your deposit. If deposits are fewer than the threshold, banks are compelled to report them if they could suggest criminal conduct.

You claimed many Itemized Deductions.

Taxpayers are expected to live within their means, according to the IRS. They work, pay their expenses, and perhaps they're fortunate enough to save and invest some of their earnings. You may face an audit if you spend a considerable portion of your income and seek tax deductions. When taxpayers itemize, this trigger usually kicks in. Mother Teresa may have been able to donate 75% of her income to charity, but this is just not an option for other people. It will also raise problems if you claim that you spent a lot of money on mortgage interest when your stated salary does not allow you to qualify for such a hefty mortgage. If you make a charitable contribution of property worth more than $500, have it appraised, acquire a receipt, and file Form 8283 with your tax return to avoid difficulty. For gifts worth more than $5,000 and some apparel and household items, appraisals are necessary.

You've Decided to Work for Yourself.

Home office deductions, mileage deductions, and deductions for meals, travel, and entertainment are available to sole proprietors and freelancers who aren't available to most other taxpayers. These costs are recorded on Schedule C and deducted from your earnings to establish your taxable business income. DIF is looking for deductions for various occupations that are beyond the average. If you're an art dealer, it's reasonable to assume that you'll spend roughly 15% of your annual income on travel because that's what other art dealers do. If you claim 30%, though, you might anticipate the IRS scrutinizing your return more closely. Have you ever paid attention to the occupational codes on your tax return? The IRS uses these to ensure that your travel expenses are consistent with those of others who report the same codes. If you've claimed a lot more than the norm for your profession, the IRS will give you a second look. Suppose you use your car for work and wish to deduct your expenses or mileage. In that case, the IRS doesn't want to hear that 100 percent of your travel was purely for business purposes, especially if you don't have another vehicle accessible for personal use. At some point, you must have driven to run personal errands.

It's a home-based business for you.

The IRS understands that taxpayers who claim home office deductions frequently make mistakes, so there could be more tax money to be had here. The unwritten rule is that you must only utilize your home office for business purposes. You and your family are unable to accomplish anything else in that place. If you want to claim a deduction for a home office, read IRS Publication 587.

You're the owner of a cash-based company.

Operating a primarily cash-based firm can also put you on the IRS' radar. Salons, restaurants, bars, car washes, and taxi services are among the businesses that fall under this category, according to the IRS. The government believes it is quite simple for cash-based business owners to slip those 50 dollars into their pockets and forget them until tax time. If your lifestyle is such that your reported income is insufficient to cover all of your expenses, a red flag will appear. How would the IRS be aware of your way of life? It collects information from concerned citizens. For example, the IRS might find out if you're driving around in a Ferrari while claiming $50,000 in income.

You claim that your hobby is a business.

Maybe you're a puppy breeder who sells puppies. Is this a sign that you're self-employed? Perhaps, but a slew of tax rules determines the distinction between a business and a pastime. If you're self-employed, you'll get all those nice Schedule C tax deductions, but if your business is a hobby, you're out of luck. If you itemize your deductions, you could deduct up to the income you got from your business, but the TCJA has removed this deduction, at least until 2025. It isn't a business if you haven't shown a net profit from your pastime in at least three of the previous five tax years. If you're breeding horses, there's an exception—two- out of every seven years in this situation. If you're starting and this is your first year at your business, you can submit Form 5213 to give yourself four more years to make a profit, but this may prompt the IRS to take a closer look. If you don't rely on the revenue to make ends meet or commit the requisite time, effort, and money to optimizing your earnings, the IRS is unlikely to consider your venture a business. In other words, you must devote much time each day to it. If you're audited, you'll need records to verify it.

You own property or have money in another country.

The IRS is especially interested in taxpayers with assets and cash stashed abroad, especially in countries with more advantageous tax regulations than the United States. The Internal Revenue Service (IRS) has tightened its requirements for abroad assets and increased its examination of such tax reports. The IRS can normally obtain information about your account from a foreign bank, and it will do so if it believes you owe taxes on the funds you've placed there. In reality, certain international banks are required to give lists of American account holders to the IRS. On FinCEN Form 114, you must declare all overseas accounts with total cumulative balances of more than $10,000. IRS Form 8938 must disclose 12 foreign assets worth $50,000 or more.

You Earn Money From Your Investments

Remember that the IRS obtains copies of all tax returns that include your Social Security number. It's too easy to overlook or misunderstand some of them, especially when dealing with investing. The IRS will be on the lookout for those 1099 documents that will arrive after the first of the year. If the IRS gets 1099 indicating that you were paid interest or dividends and the interest or dividends were not declared on your tax return, you will receive a letter from the IRS. If you merely agree to the income adjustment and pay the related tax, the letter should not result in a full-fledged audit.

You applied for and received the Earned Income Tax Credit (EITC)

Claiming the Earned Income Tax Credit can lead to an audit, but you'll likely be unaware that the IRS is looking into your return. The EITC is a refundable tax credit that grows in proportion to the number of dependent children you have. There are also income limits that must be met to qualify. If you're eligible for the EITC and the amount of credit you qualify for exceeds the tax you owe, the IRS sends you a check for the difference.

Don't Worry About Math.

Mathematical errors do not cause the bulk of tax audits. They happen because something about your financial status has put you in a category with the IRS that signals you may owe more money in taxes than you claim. On the plus side, the IRS reported that over 20,000 of the 738,959 audits completed that year resulted in increased refunds for taxpayers. If your deductions are valid, claim them; you are entitled to them. If you're requested to prove or substantiate your claims, be ready to do so.

Most Commonly Asked Questions

Is there a limit to how far back the IRS can investigate?

An audit by the IRS can encompass returns from the previous three years. In most cases, it has three years to assess additional taxes. You don't have to agree to an extension of the statute of limitations if it asks for one. If the IRS discovers certain irregularities, they can add additional years. The IRS has six years to investigate if the taxpayer's gross income is understated by more than 25%.

In the event of an audit, how long should you maintain your tax records?

Keep your tax records for three years following the due date or filing date of your return, whichever comes first. If you have unique sources of income, such as partnership interests, keep your records for six or seven years. Records of inherited and purchased assets and the expenses of upgrades should be retained until the statute of limitations for the year of sale or other disposition ends. If you don't file a return, the IRS suggests preserving your data permanently because the statute of limitations will not apply. It won't start running until you file a return.