The Internal Revenue Service has continued to slash their budget year after year. In fact, the IRS budget for 2017 is $236 million less than the previous year, representing a $900 million reduction since 2010. These funding cuts have resulted in hiring freezes and a significant reduction in the number of both taxpayer support personnel and criminal investigators. With nearly 17,000 fewer personnel in the last 6 years, it is no wonder that IRS commissioner John Koskinen noted at the American Institute of CPA’s National Conference “you can’t keep shrinking the agency without jeopardizing its mission.” Koskinen also added that “The agency estimates that $5 billion remains uncollected from tax returns that should be audited, but the IRS lacks the staff to do it.” While a reduced budget may result in fewer audits, it is important for taxpayers to avoid being complacent as certain activities greatly enhance your chances of being audited. Consider reviewing the red flags noted below to further reduce your chances of a run-in with the IRS this tax season.
Careless errors - the most avoidable Audit Red Flags
Minimizing simple errors is one of the easiest ways to reduce the amount of attention the IRS gives to your return. Incorrect social security numbers, rudimentary mathematical mistakes and other silly typos can lead to additional IRS scrutiny. Carefully double-checking your return may help to prevent these often overlooked and easily avoidable errors. As they say, where there is smoke there is fire and errors can often alert the IRS to other issues in your return.
The higher the income the more you are worth their time.
With fewer audit resources, the IRS is forced to get the greatest return on their investment. As a result, your chances of being audited increase exponentially as income rises. According to the latest IRS statistics, approximately .80 percent of individual returns – roughly one in 100 taxpayers were audited. The chances of being audited increase to nearly 2 percent for taxpayers earning between $200,000 and $1,000,000. Tax Filers with earnings greater than $1 million experienced a jump in the audit rate to 10 percent. In addition to wealthy individuals, those filing international returns also had higher incidents of audit – approximately 4 percent. Simply put – high wage earners with more complicated returns tend to be the “low lying fruit” the IRS can devote their limited resources to so be careful if you fall within this category.
Larger charitable deductions than other taxpayers at your income level
Making a difference in the lives of others by supporting a charity can be mutually beneficial – assisting the charity while limiting your tax liability in the process. However, it is important to be aware your risk of audit increases if you are donating a disproportionately larger sum than the average taxpayer at your income level. Christine Darcy, CPA of Darcy & Connolly CPAs, LLC of Spring Lake Heights NJ notes, “Taxpayers should consider the way the IRS will review their tax return using the economic reality theory –is your level of charitable contributions realistic for someone with your level of income? If you have the receipts to support the deduction on the tax return you are fine, if not, be prepared for the numbers to be challenged if they are higher than expected for your income level.” Despite these concerns, be careful not to allow the fear of an IRS audit to limit your charitable endeavors. Instead, be sure to be diligent when documenting all charitable contributions according to IRS rules. Reviewing IRS Publication 526 - Charitable Contributions and Publication 561 - Determining the Value of Donated Property can help ensure you can substantiate all tax-deductible contributions on your return.
Failing to report all of your income - one of the most common of all Audit Red Flags
Various forms of income are provided to the IRS from outside sources such as your employer, financial institution and retirement plan. Failing to report all income received on W2s, 1099s, etc. can cause the IRS to raise an eyebrow. Remember, they cross reference these forms against data provided on your return for any inconsistencies. Whether intentional or not, leaving out income that may be reported to the IRS from other sources can signal that your return needs a closer look. Consider taking special care to ensure that all income is accurate and accounted for.
High business deductions for automobiles, meals, travel and entertainment
The more common a tax deduction is abused by taxpayers, the more likely the IRS will be to carefully scrutinize those perceived to be taking advantage. Excessively high business deductions for automobiles, meals, travel and entertainment would certainly fall into this category. Many business owners attempt to deduct 100 percent of the cost of their personal vehicle – often throwing up a red flag to the IRS. Remember, the automobile deductions for business use cannot include personal use and most meet specific criteria for deductibility. Be sure to substantiate business use with detailed logs noting mileage and destinations for business travel.
Additionally, business owners often push the envelope by deducting personal meals, personal travel and personal entertainment as deductible business expenses. Be sure that you are limiting your deductions to allowable business expenses while also maintaining supporting documentation.
In addition to excessive business deductions for automobiles, travel and entertainment, owning a “cash business” may increase the chances of your return being targeted for an audit. From restaurants and carwashes to hair salons and laundromats, cash intensive businesses tend receive more IRS scrutiny than other businesses. In addition, workers who receive a large percentage of their income in the form of cash tips should also be careful. The IRS may be understaffed but they certainly understand that the use of cash can lead to inaccuracies in the reporting of income and expenses. Cash industries should work with their accountant to ensure accurate reporting of income and expenses.
While the IRS has fewer agents and the chances of audit may be falling, taxpayers should work with their accountant and advisers to further minimize the chances of an IRS audit. Should you find an IRS audit letter in your mailbox, consider reviewing IRS Publication 556 - Examination of Returns, Appeal Rights and Claims for Refund for additional information on audit procedures. Since everyone’s tax situation is unique, consider speaking to your CPA to determine the most appropriate approach for you.