Red flags may prompt IRS audit

red flagIn an effort to increase revenue and combat tax fraud, the federal government actively audits returns. While the overall audit rate for individual returns is approximately 1 percent, ignoring the red flags noted below can greatly increase the chances of an audit.

The good news is that a proactive approach to tax planning can help reduce the likelihood of a surprise visit from the Internal Revenue Service.

Failing to report income

The IRS uses computers to improve the efficiency of its operations — especially for audit purposes. Copies of many tax forms, including W2s, 1099s, 5498 for retirement plan balances and others, are received by the IRS and used as the basis for cross-checking the data contained on your return.

Failing to properly report income and specifically matching the income on your return to your tax documents may increase your chances of an audit.

Consider taking an inventory of all income sources and double-checking that all are properly reported.

Earning too much

While there are not many people who would like to earn less income, it is important to be aware of how your income level affects the probability of an audit. Since the IRS has limited resources and can audit only so many returns, the more you make, the greater the chances.

For example, audit rates jump from 1 percent to 4 percent for tax payers earning greater than $200,000 and taxpayers earning more than $1 million can expect an audit rate of 12.5 percent. This also holds true for businesses as the greater the income, the higher the probability of being audited.

Large cash transactions

Cash transactions in excess of $10,000 involving banks, casinos, car dealers and other business are required to be filed with the IRS. In addition, suspicious transactions less than $10,000 may also be reported to the IRS. Both of which may be used to identify taxpayer returns the IRS believes should be further scrutinized during an audit.

Large charitable deductions

Charitable giving is a great way to help those in need while also enjoying a nice tax deduction. Keep in mind, the IRS maintains statistics for charitable giving at various income levels.

If you are donating significantly more than the average taxpayer at your income level, you may increase your chances of an audit.

Remember to carefully document all charitable contributions. Consider reviewing IRS Publication 526 on charitable contributions and Publication 561 on determining the value of donated property for more information.

Deducting home office

Claiming a home office deduction can provide significant tax savings to taxpayers for property taxes, insurance, utilities and other expenses. The attractiveness of these deductions has led to taxpayer abuse and as a result, heightened IRS scrutiny.

According to Gary Pesciotta of Redvanly and Pesciotta CPA's LLC, “Home office deductions are one of the biggest audit red flags and taxpayers must be aware of the exclusive use rules.”

For example, a dining room cannot be used as a deductible home office since it is not being used exclusively and regularly for business purposes.

Consider reviewing Publication 587 regarding business use of a home and speak to your tax adviser for more information.

Cash businesses

Operating cash-intensive businesses such as hair salons, restaurants, bars, car washes and others may lead to your return being targeted for an audit. The IRS understands that the use of cash can lead to inaccuracies in the accounting of income and expenses and are more than happy to review the return further.

Deducting 100 percent of your automobile

Claiming a business vehicle is yet another popular deduction that is often abused by taxpayers. The IRS knows it is uncommon for a vehicle to be used 100 percent of the time for business with no personal use.

If you are going to take an automobile deduction for business use, remember to keep detailed logs with date, destination and mileage clearly noted.

For additional information, consider reviewing Publication 463 on travel, entertainment, gift and car expenses.

Simple errors

Making silly mathematical mistakes on your return and other typos such as Social Security number errors can lead to further investigation.

IRS computers can quickly identify these errors which may require additional follow-up or even an audit. Check your return for these often overlooked errors.

There are many red flags that could trigger your tax return being audited this tax season. However, the risk of audit should not lead you to avoid taking deductions that you are legitimately entitled to claim.

For more information on the audit process, consider reviewing IRS Publication 556 on examination of returns, appeal rights and claims for refund. Since everyone’s tax situation is unique, consider speaking to your accountant to determine the appropriate approach for you.

 

Kurt J. Rossi, MBA, is a Certified Financial Planner Practitioner. He can be reached for questions at 732-280-7550 or kurt.rossi@Independentwm.com