Ever wonder why some tax returns are eyeballed by the Internal Revenue Service
while most are ignored?
The IRS audits only slightly more than 1% of all
individual tax returns annually. The agency doesn't have enough personnel and
resources to examine each and every tax return filed during a year. So the odds
are pretty low that your return will be picked for review. And, of course, the
only reason filers should worry about an audit is if they are fudging on their
taxes.
However, the chances of being audited or otherwise hearing from
the IRS increase depending upon various factors, including your income level,
whether you omitted income, the types of deductions or losses you claimed, the
business in which you're engaged and whether you own foreign assets. Math errors
may draw IRS inquiry, but they'll rarely lead to a full-blown exam. Although
there's no sure way to avoid an IRS audit, you should be aware of red flags that
could increase your chances of drawing unwanted attention from the
IRS.
1. Making too much money
Although the
overall individual audit rate is about 1.11%, the odds increase dramatically for
higher-income filers. IRS statistics show that people with incomes of $200,000
or higher had an audit rate of 3.93%, or one out of slightly more than every 25
returns. Report $1 million or more of income? There's a one-in-eight chance your
return will be audited. The audit rate drops significantly for filers making
less than $200,000: Only 1.02% of such returns were audited during 2011, and the
vast majority of these exams were conducted by mail. We're not saying you should
try to make less money -- everyone wants to be a millionaire. Just understand
that the more income shown on your return, the more likely it is that you'll be
hearing from the IRS.
2. Failing to report all taxable income
The
IRS gets copies of all 1099s and W-2s you receive, so make sure you report all
required income on your return. IRS computers are pretty good at matching the
numbers on the forms with the income shown on your return. A mismatch sends up a
red flag and causes the IRS computers to spit out a bill. If you receive a 1099
showing income that isn't yours or listing incorrect income, get the issuer to
file a correct form with the IRS.
3. Taking large charitable
deductions
We all know that charitable contributions are a great
write-off and help you feel all warm and fuzzy inside. However, if your
charitable deductions are disproportionately large compared with your income, it
raises a red flag. That's because IRS computers know what the average charitable
donation is for folks at your income level. Also, if you don't get an appraisal
for donations of valuable property, or if you fail to file Form 8283 for
donations over $500, the chances of audit increase. And if you've donated a
conservation easement to a charity, chances are good that you'll hear from the
IRS. Be sure to keep all your supporting documents, including receipts for cash
and property contributions made during the year, and abide by the documentation
rules. And attach Form 8283 if required.
4. Claiming the home
office deduction
Like Willie Sutton robbing banks (because
that's where the money is), the IRS is drawn to returns that claim home office
write-offs because it has found great success knocking down the deduction and
driving up the amount of tax collected for the government. 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. That's a great deal.
However, to take this write-off, you must use the space exclusively and
regularly as your principal place of business. That makes it difficult to
successfully claim a guest bedroom or children's playroom as a home office, even
if you also use the space to do your work. "Exclusive use" means that a specific
area of the home is used only for trade or business, not also for the family to
watch TV at night. Don't be afraid to take the home office deduction if you're
entitled to it. Risk of audit should not keep you from taking legitimate
deductions. If you have it and can prove it, then use it.
5.
Claiming rental losses
Normally, the passive loss rules prevent
the deduction of rental
real
estate losses. But there are two important exceptions. If you actively
participate in the renting of your property, you can deduct up to $25,000 of
loss against your other income. But this $25,000 allowance phases out as
adjusted gross income exceeds $100,000 and disappears entirely once your AGI
reaches $150,000. A second exception applies to
real estate professionals who spend more than 50% of
their working hours and 750 or more hours each year materially participating in
real estate as developers,
brokers, landlords or the like. They can write off losses without limitation.
But the IRS is scrutinizing rental
real estate losses, especially those written off by
taxpayers claiming to be
real
estate pros. The agency will check to see whether they worked the
necessary hours, especially in cases of landlords whose day jobs are not in the
real estate
business.
6. Deducting business meals, travel and
entertainment
Schedule C is a treasure trove of
tax deductions for self-employeds.
But it's also a gold mine for IRS agents, who know from experience that
self-employeds sometimes claim excessive deductions. History shows that most
underreporting of income and overstating of deductions are done by those who are
self-employed. And the IRS looks at both higher-grossing sole proprietorships
and smaller ones.
Big deductions for meals, travel and entertainment are
always ripe for audit. A large write-off here will set off alarm bells,
especially if the amount seems too high for the business. Agents are on the
lookout for personal meals or claims that don't satisfy the strict
substantiation rules. To qualify for meal or entertainment deductions, you must
keep detailed records that document for each expense the amount, the place, the
people attending, the business purpose and the nature of the discussion or
meeting. Also, you must keep receipts for expenditures over $75 or for any
expense for lodging while traveling away from home. Without proper
documentation, your deduction is toast.
[Also see:
7 ways to score free stuff]
7. Claiming 100%
business use of a vehicle
Another area 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 of an automobile is red meat for IRS agents. They know that it's
extremely rare for an individual to actually use a vehicle 100% of the time for
business, especially if no other vehicle is available for personal use. IRS
agents are trained to focus on this issue and will scrutinize your records. Make
sure you keep detailed mileage logs and precise calendar entries for the purpose
of every road trip. Sloppy recordkeeping makes it easy for the revenue agent to
disallow your deduction. As a reminder, if you use the IRS' standard mileage
rate, you can't also claim actual expenses for maintenance, insurance and other
out-of-pocket costs. The IRS has seen such shenanigans and is on the lookout for
more.
8. Writing off 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 the
loss-generating activity sounds like a hobby -- horse breeding, car racing and
such -- the IRS pays even more attention. Agents are specially trained to sniff
out those who improperly deduct hobby losses. Large Schedule C losses are always
audit bait, but reporting losses from activities in which it looks like you're
having a good time all but guarantees IRS scrutiny.
You must report any
income you earn from a hobby, and you can deduct expenses up to the level of
that income. But the law bans writing off losses from a hobby. For you to claim
a loss, your activity must be entered into and conducted with the reasonable
expectation of making a profit. If your activity generates profit three out of
every five years (or two out of seven years for horse breeding), the law
presumes that you're in business to make a profit, unless IRS establishes
otherwise. If you're audited, the IRS is going to make you prove you have a
legitimate business and not a hobby. So make sure you run your activity in a
businesslike manner and can provide supporting documents for all
expenses.
9. Running a cash business
Small
business owners, especially those in cash-intensive businesses -- think taxis,
car washes, bars, hair salons, restaurants and the like -- are a tempting target
for IRS auditors. Experience shows that those who receive primarily cash are
less likely to accurately report all of their
taxable income. The IRS has a guide for agents to use
when auditing cash-intensive businesses, telling how to interview owners and
noting various indicators of unreported income.
10. Failing to
report a foreign bank account
The IRS is intensely interested in
people with offshore accounts, especially those in tax havens, and tax
authorities have had success getting foreign banks to disclose account
information. The IRS has also used voluntary compliance programs to encourage
folks with undisclosed foreign accounts to come clean -- in exchange for reduced
penalties. The IRS has learned a lot from these programs and has collected a
boatload of money ($4.4 billion so far).
Failure to report a foreign bank
account can lead to severe penalties, and the IRS has made this issue a top
priority. Make sure that if you have any such accounts, you properly report them
when you file your return.
11. Engaging in currency
transactions
The IRS gets many reports of cash transactions in
excess of $10,000 involving banks, casinos, car dealers and other businesses,
plus suspicious-activity reports from banks and disclosures of foreign accounts.
A report by Treasury inspectors concluded that these currency transaction
reports are a valuable source of audit leads for sniffing out unreported income.
The IRS agrees, and it will make greater use of these forms in its audit
process. So if you make large cash purchases or deposits, be prepared for IRS
scrutiny. Also, be aware that banks and other institutions file reports on
suspicious activities that appear to avoid the currency transaction rules (such
as persons depositing $9,500 in cash one day and an additional $9,500 in cash
two days later).
12. Taking higher-than-average
deductions
If deductions on your return are disproportionately
large compared with your income, the IRS may pull your return for review. But if
you have the proper documentation for your deduction, don't be afraid to claim
it. There's no reason to ever pay the IRS more tax than you actually owe.