Red Flags for Tax Auditors
No one wants to see an Internal Revenue Service (IRS) tax auditor show up at their door. In 2018, the IRS budget is roughly $1 billion less than it was 8 years ago, down from $12.1 billion in 2010 to $11.2 billion. And even though the number of audits has dropped 40 percent from 2010 to 2017, an IRS tax audit remains a fear for many individuals.[i]
The IRS can’t audit every American’s federal tax return, so it relies on guidelines to select the ones most deserving of its attention. Here are six flags that could make your tax return ripe for an IRS audit.
The chance of an audit rises with income. According to the IRS, less than 1% of all individual taxpayer returns are audited. However, the percent of audits rises to over 1.5% for those with incomes between $200,000 and $1 million who attach Schedule C and is over 4% for those making more than $1 million annually.[ii]
If this year’s 1040 deviates greatly from last year’s, that could raise a red flag. The IRS has a scoring system called the Discriminant Information Function (DIF) that is based on the deduction, credit, and exemption norms for taxpayers in each of the income brackets. The agency does not disclose its formula for identifying aberrations that trigger an audit, but it helps if your return data is within the range of other taxpayers with similar incomes.[iii]
If your business passes for a hobby, you could be scrutinized. Taxpayers who repeatedly report yearly business losses on Schedule C increase their audit risk. In order for the IRS not to consider your business as a hobby, it typically needs to have earned a profit in three of the last five years.2
Not fully reporting your income boosts the chances of an audit. The IRS receives copies of all of your 1099 and W-2 forms. Individuals who overlook reported income are easily identified and may provoke greater scrutiny.2
Alimony discrepancies between exes can raise eyebrows. When divorced spouses prepare individual tax returns, the IRS compares the separate submissions to identify instances where alimony payments are reported on one return, but alimony income goes unreported on the other party’s return.2 Keep in mind that The Tax Cuts and Jobs Act repealed the alimony deduction after December 31, 2018.
If you claim rental losses, you had better be a real estate professional. Passive loss rules prevent deductions of losses on rental real estate, except in the event you are actively participating in a property’s management as a developer, broker, or landlord (the deduction is limited to $25,000 and begins to phase out when adjusted gross income exceeds $100,000) or you are devoting more than 50% of your working hours to this activity. This is a deduction to which the IRS pays keen attention.2
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[i] https://www.washingtonpost.com/business/economy/your-chances-of-an-irs-audit-are-way-down-but-keep-it-on-the-up-and-up/2018/04/06/cb6c5794-3779-11e8-9c0a-85d477d9a226_story.html?utm_term=.77485a954004
[ii] https://www.kiplinger.com/slideshow/taxes/T056-S001-red-flags-for-irs-auditors/index.html
[iii] https://www.cpapracticeadvisor.com/news/12418908/how-to-prepare-your-clients-for-an-irs-tax-audit
Financial Advisor, Tax Auditors, Tax Returns, Taxes, Wealth Management
