The IRS receives copies of all 1099s and W-2s that you receive and their computers will match up your submission to these records so it is vital that you report all required income on your tax return. Here are some flags the IRS takes advantage of. Note: Some of these items will cause the IRS to send a letter requesting an explanation or revising taxes, but most times not cause an audit.
Returns claiming the home-buyer credit
First-time homebuyers and longtime homeowners who claimed the homebuyer credit should be prepared for IRS scrutiny. Make sure you submit proper documentation when taking this credit. Also, the IRS has ways of policing the recapture of the homebuyer credit. Generally, the credit is required to be recaptured if the home is sold within three years for homes brought in 2009 or 2010 and within 15 years for homes bought before 2009. The IRS is checking public real estate databases for sales of homes for which the credit was taken.
Claiming large charitable deductions
This comes up again and again because the IRS has found abuse on audit, especially with those taking larger deductions. We all know that charitable contributions are a great write-off and help you to feel all warm and fuzzy inside. However, if your charitable deductions are disproportionately large compared to your income, it raises a red flag.
Home office deduction
The IRS is always very interested in this deduction, primarily because it has a pretty high adjustment rate on audit. This is because history has shown that many people who claim a home office don’t meet all the requirements for properly taking the deduction, and others may overstate the benefit. If you qualify, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance, and other costs that are properly allocated to the home office.
Business meals, travel and entertainment
Schedule C is a treasure trove of tax deductions for the self-employed. But it’s also a gold mine for IRS agents, who know from past experience that the self-employed tend to claim excessive deductions. Most under-reporting of income and overstating of deductions are done by those who are self-employed.
Claiming 100% business use of vehicle
Another area that is ripe for IRS review is use of a business vehicle. When you depreciate a car, you have to list on Form 4562 what percentage of its use during the year was for business. Claiming 100% business use for an automobile on Schedule C is red meat for IRS agents.
Claiming a loss for a hobby activity
Your chances of “winning” the audit lottery increase if you have wage income and file a Schedule C with large losses. And, if your Schedule C loss-generating activity sounds like a hobby…horse breeding, car racing, and such…the IRS pays even more attention. Cash businesses
Small business owners, especially those in cash-intensive businesses…taxi drivers, car washes, bars, hair salons, restaurants and the like…are an easy target for IRS auditors. The agency is well aware that those who primarily receive cash in their business are less likely to accurately report all of their taxable income. Failure to report a foreign bank account
The IRS is intensely interested in people with offshore accounts, especially those in tax havens. U.S. tax authorities have had some recent success in trying to get foreign banks (such as UBS in Switzerland) to disclose information on U.S. account holders. The IRS has learned a lot from these probes.
One of the biggest reasons that people receive a letter from the IRS is because of mathematical mistakes they make on their tax returns. Taking higher-than-average deductions
If deductions on your return are disproportionately large compared to your income, the IRS audit formulas take this into account when selecting returns for examination.
It’s unlikely that your investment returns were exactly $500, or that your mortgage interest deduction was $10,000. Too many round numbers on a return are a symptom that something fishy may be going on. Family members on the payroll
One common tax dodge is to “hire” a family member in order to take more money out of a business. There’s nothing wrong with employing family members as long as they’re actually working. Getting a CP2000 letter for mismatched income is not as burdensome as an audit. A letter correcting apparent math errors is also not an audit. I do not agree with the premise that these items above will always result in an audit but they MAY cause an audit or at least a review of some type.
Given the rise in the number of SOHO (small office/home office) businesses I have not seen a home office deduction audited in many years and have no problem including it on a tax return. Clearly any legal deduction should be taken because the IRS is not going to write you a letter and ask if you have any additional deductions not already claimed.