What is an IRS Audit?
An IRS audit is a review/examination of an organization’s or individual’s accounts and financial information to ensure information is reported correctly according to the tax laws and to verify the reported amount of tax is correct.
What is a Red Flag?
Every single tax return filed with the IRS is placed through a computer screening process. A return can be selected for audit by the computer-scoring system known as “Discriminant Information Function”, or DIF. Returns are randomly selected and “flagged” by computers when they are out of the ordinary and fall outside of the statistical “norms”. When a return is “flagged”, it is likely subject for review by an IRS employee to determine if there is really a need for audit. A return that generates enough “audit flags” or “red flags” causes the return to be reviewed and possibly audited.
Common Red Flags
There are various factors that trigger a return to be flagged and be subjected to examination and audit by the IRS. Here are some of the most common red flags that every taxpayer should be aware of:
Income tax returns are reviewed by the IRS computers for math errors (incorrect calculations or use of wrong tax table) and incomplete information (unreported W-2 or other income). If the computer senses an error of what you’ve filed, your return will be subject to a more thorough review. This is one reason why using a tax software is useful to make sure that the math on the return is correct.
To claim the expense as a business deduction, your expense must be both ordinary and necessary. Ordinary and necessary expense refers to an expense that is normal or usual. It is also appropriate for the operation of a particular trade or business. Generally, ordinary and necessary expense is paid or incurred during the taxable year. Hence, it is tax-deductible. (https://definitions.uslegal.com)
An example of an unlikely business expense is frequently taking people out to lunch and not actually having a discussion about your business. If the meal expenses are for legitimate purposes, it is advisable to keep the receipts, a record of the purpose of the meeting, and who attended the meeting.
A fair rental price for your property generally is the amount of rent that a person who is not related to you would be willing to pay. The rent you charge is not a fair rental price if it is substantially less than the rents charged for other properties that are similar to your property in your area. (https://www.irs.gov/publications/p527/ch05.html).
If you are charging rent below the fair rental price, the IRS may review property tax and interest records to determine the value and market rent for the property.
The IRS statistics for 2016 show that people with an income of $200,000 or higher had an audit rate of 1.70%, or one out of every 59 returns. Report $1 million or more of income, There’s a one-in-17 chance your return will be audited. The audit rate drops significantly for filers making less than $200,000: Only 0.65% (one out of 154) of such returns were audited during 2016. (http://www.kiplinger.com/slideshow/taxes/T056-S011-red-flags-that-can-raise-your-irs-audit-risk/index.html)
Home office deduction is commonly considered a red flag, especially if you are claiming a substantial deduction in comparison to your business income. Claiming both a home office and a rented office space and a significant amount of expenses for home maintenance and utilities triggers the IRS to pay more attention to your return.
To avoid this type of red flag, the home office deduction should be tied to the income derived from the business. In addition, the home office should be used regularly and exclusively for business.
Vehicle expenses for business use are deductible. You can either choose between using the IRS standard mileage rate or actual expenses, but not both. Deducting both will trigger red flags on your return. Also, be very careful when claiming 100 percent business use for a vehicle because this will increase the chances of an IRS audit.
Charitable donations that are higher than the average for your income level triggers a red flag. Appraise your charitable donations in-kind accurately, and file Form 8283 with your return for donations that are in excess of $500.
The Foreign Account Tax Compliance Act requires overseas banks to identify American asset holders and provide information to the IRS. Individuals must report foreign assets by filing FinCEN Form 114 for assets more than $10,000 at any point in the prior year. For assets worth at least $50,000, individuals must report them on the new Form 8938. Failing to comply with the requirements of the law can lead to severe penalties and an audit by the IRS.
Amounts paid to a spouse or a former spouse under a divorce or separation instrument (including a divorce decree, a separate maintenance decree, or a written separation agreement) may be considered alimony for federal tax purposes. (https://www.irs.gov/taxtopics/tc452.html)
Alimony is deductible to the payer spouse and taxable to the recipient, provided certain requirements under the law are met. A mismatch in the reporting by ex-spouses may result in an audit.
The IRS particularly watches a taxpayer that has a regular job and at the same time file a Schedule C that show losses in his return. Businesses that operate primarily with cash and report a loss for several consecutive years elicit the attention of the IRS. If a “business” doesn’t make any money, it could be considered a hobby by the IRS, and losses from a hobby aren’t deductible.
Internal Revenue Code Section 183 (Activities Not Engaged in for Profit) limits deductions that can be claimed when an activity is not engaged in for profit and sometimes referred to as the “hobby loss rule.” (https://www.irs.gov/uac/is-your-hobby-a-for-profit-endeavor)
What to Do If You Are Selected for Audit
If you are selected for audit, the IRS will notify you by mail on official letterhead. The IRS does not initiate an audit by telephone, text messages or E-mail (for more information about E-mail scams, read the blog on “How to Recognize and Handle E-mail Scams“) The IRS will provide you with a written request for the specific documents they want to see. The IRS will provide all contact information and instructions in the letter you will receive.
Keep calm, organize and submit all the specific documents being requested, be honest and only answer the questions being asked, and know your rights as a taxpayer.