Beware of audit red flags this tax season

audit red flags 1-2015Most taxpayers would rather not receive correspondence from the Internal Revenue Service – especially if it's in the form of a dreaded audit letter. While it is believed that IRS budget cuts and hiring freezes could delay refunds and reduce the number of audits this year, certain red flags will undoubtedly increase the chances of a tax inquiry.

Generally, most tax audit letters simply ask for details and supporting documentation pertaining to a specific item on your return. Alternatively, if enough red flags are present, the IRS may request a deeper dive involving an audit of your entire return.

The good news is that there are simple steps that can be taken to avoid drawing unnecessary attention to your return this tax season.

Typos and silly errors

One of the most common yet avoidable ways to draw attention to your tax return is to make simple errors. From basic mathematical mistakes on your return to other typos and oversights such as an incorrect Social Security number, silly errors can lead to a serious investigation. Consider carefully double-checking your return to prevent these often overlooked errors.

Too much income

While higher levels of income are certainly a good problem to have, they can substantially increase the probability of an audit. According to IRS statistics for 2013, about 0.96 percent of individual returns, or roughly one in 100 taxpayers, was audited. Audit rates increase to 3.26 percent or one out of every 30 returns for taxpayers earning greater than $200,000. Filers earning greater than $1 million had an audit rate of one in every nine returns. Since the stakes are higher when your earnings are greater, the IRS’ limited resources forces it to strategically focus its efforts on higher-wage earners.

Failing to report all of your income

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, the IRS cross-references 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.

Taking rental losses

From tax-deductible expenses such as repairs and maintenance to depreciation expenses, it is not uncommon for rental property owners to realize losses on their tax return from rental activity. These tax losses can be deductible by certain landlords depending on their income level. Property owners with modified adjusted gross incomes of $100,000 or less may deduct up to $25,000 in rental real estate losses per year if they "actively participate" in the rental activity. This deduction can be significant, often leading many property owners to overinflate expenses in order to avoid paying tax on passive income. Be sure you have supporting documentation for all deductible expenses associated with the property prior to taking a rental loss. See publication 925 – Passive Activity Loss Rules for more information.

Disproportionately large charitable giving

Supporting your favorite charity is a great way to help others while limiting your tax liability. However, if you are donating significantly more than the average taxpayer at your income level, you may increase your chances of an audit. While disproportionate levels of charitable giving can lead to an IRS review, do not allow the fear of an IRS audit letter prevent you from helping those in need. Simply take special care to document all charitable contributions according to IRS rules. Consider reviewing IRS Publication 526 – Charitable Contributions and Publication 561 – Determining the Value of Donated Property for more information.

High business deductions for automobiles, meals, travel and entertainment

This is another deduction that is sometimes abused by business taxpayers, resulting in careful IRS scrutiny. If you are going to take an automobile deduction for business use, be certain it meets the criteria for deductibility and remember to keep detailed logs with dates, destination and mileage clearly noted. The IRS knows that is uncommon for a vehicle to be used 100 percent of the time for business with no personal use so be careful not to abuse this deduction.

Additionally, personal meals, travel and entertainment often masquerade as deductible business expenses. For example, purchasing and attempting to deduct tickets to the Super Bowl could certainly send off a few red flags. Be sure that you are deducting only allowable business expenses with good supporting documentation. For additional information, consider reviewing Publication 463 – Travel, Entertainment, Gift and Car Expenses.

While there are many areas of the tax code the IRS has chosen to scrutinize, the fear of an audit should not cause you to avoid taking legitimate deductions you are entitled to. Taxpayers pushing the envelope of what may be allowable should keep in mind they probably have much more to lose than they stand to gain. 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 accountant to determine the appropriate approach for you.

 

Kurt J. Rossi, MBA is a Certified Financial Planner, Practitioner & Wealth Adviser. He can be reached for questions at 732-280-7550, kurt.rossi@Independentwm.com or www.Independentwm.com. LPL Financial Member FINRA/SIPC.