Recent IRS statistics indicate that people with income of $200,000 or higher had an audit rate of 3.26%. People with income of $1 million or more have a one-in-nine chance of being audited. On the other hand, only .88% of tax returns reflecting income of less than $200,000 were audited and those audits were correspondence audits conducted by mail rather than in person. So unless you’re making a lot of money your chances to be chosen for an audit is fortunately not that great.
While some returns are selected randomly for audits, the IRS is looking for anything that looks out of the ordinary on the return, deductions other tax payers typically have misused, mismatches of what’s being reported on the return and the source documents received by the IRS.
The following are 10 items on your tax return that can cause red flags for the IRS:
1. Failing to Report All Taxable Income: Remember that the IRS receives a copy of all your 1099s and W-2s. Leaving something out will attract their attention and they may wonder what else you’re not reporting correctly.
2. Taking Higher-than-Average Deductions: The IRS looks for anything that looks unusual. Make sure you have receipts and supporting documents to back up all your deductions.
3. Claiming Rental and Passive Losses: Losses from rental real estate activities are generally not deductible. However, if the taxpayer actively participates in managing the rental properties, he or she can deduct up to $25,000 of losses against other income (subject to income limitations). Also, 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, or landlords may deduct all of their rental losses.
Passive losses from investments where the taxpayer does not actively participate are also limited and can only offset other passive income.
4. Writing off a Loss for a Hobby Activity: All income from a hobby must be reported, but expenses related to the hobby can only be deducted up to the amount of income earned from the hobby. Hobby losses can’t be claimed. The IRS is aware that the temptation is great for tax payers to create schedule C businesses that incur losses for a tax write off. According to the law your business, in general, should generate profit 3 out of 5 years in order to not be considered a hobby by the IRS. Make sure you keep all the receipts for expenses and other documentation.
5. Deducting Business Meals, Travel and Entertainment: The IRS is scrutinizing these types of expenses, especially if they seem large and out of the ordinary for your type of business. In general, only 50% of meals and entertainment are deductible. The tax deduction will not be allowed unless you have adequate documentation of the expense with a specified business purpose. An account book, log, expense statement, or trip sheet should be maintained along with documentary evidence (receipts, e.g.). A restaurant receipt is sufficient for a business meal if it includes the name and location of the restaurant, the date and amount of the expenditure, and the number of people served. A written hotel receipt must be maintained for lodging expenses of at least $75.
6. Claiming 100% or Unusually High Business Use of a Vehicle: If no other vehicle is available for personal use, the IRS expects that some reasonable use of vehicle is personal. Make sure you have adequate records of the amount, time and place, business purpose, and business relationship of people visited for the claimed business use. An account book, log, expense statement, or trip sheet should be maintained along with documentary evidence (receipts, e.g.).
7. Having a Large Number of Contractors Working for You: The IRS is on the lookout for employers who try to avoid paying payroll taxes by classifying their employees as contractors. The IRS and the courts have developed guidance to help employers determine whether a worker should be classified as an employee or as an independent contractor. If independent contractors should have been treated as employees instead, the IRS may assess back payroll taxes, penalties, and interest.
8. Claiming the Home Office Deduction: The IRS is aware that many taxpayers abuse the home office deduction to reduce their taxes. Tax returns with schedule C losses or only W-2 income are more likely to be scrutinized. The IRS has disallowed the business home office deductions in court cases where a television was located in the home office. Make sure you use the home office solely for your principal place of business and never for any personal use. As with all other deductions make sure you keep all your documentation.
9. Reporting Low Income for Your Profession: The IRS knows what someone in your profession is making on average, so if your income is very low it’ll raise questions about whether or not you’re reporting all your income.
Owners of S-Corporations are allowed to take distributions in addition to their W-2 income from their business. Payroll tax is not paid on distributions so naturally a business owner would like to reduce his W-2 income and receive more distributions. The IRS requires that the owners pay themselves a reasonable salary for the type of industry they are in.
10. Amending Your Tax Return: An amended return is not necessarily a red flag for the IRS, but it does cause a second review and more scrutiny of the return. Amend the return if it’s warranted. You don’t want to miss out on a refund or a lower tax bill if you’re entitled to it. It’s your money!
Allen & Company, PC - a CPA firm serving Kennesaw, Marietta, Acworth, Woodstock and north Atlanta. Providing accounting, financial statement audit, taxation, and advisory services for individuals and businesses. Extensive experience working with franchised quick service restaurants and other franchised businesses.