In most of our previous posts, we’ve been busy revealing all of the ways to help you save on taxes and claim every deduction and tax credit as much as you can.
Now, we want to help you avoid an IRS audit!
Although your chances of being audited in general are pretty low, there are certain IRS audit red flags that increase your odds dramatically.
And, the IRS loves catching them.
Note that this post is for educational purposes and you should contact your attorney or legal professional for specific advice for your situation.
8 IRS Audit Red Flags to Watch Out For
1. Not Reporting Taxable Income
The first one on our list of IRS audit red flags is failing to report your taxable income.
And it is likely the most common red flag there is. It is also one that is easy for the IRS to catch.
When you earn income from another business, you typically receive either a 1099 or W-2 documenting the income.
But you’re not alone because the IRS also receives a W-2 or 1099 documenting the income you received.
For this reason, any mismatch between the income you report on your return and the income shown via your 1099s or W-2s will raise a red flag.
To avoid any issues, report all income you receive no matter how small the amount.
This includes things you may not think of such as credit card cashback rewards or dividend income.
And even a recent referral fee you received from an apartment complex will come with a 1099.
2. Deducting Losses From a Hobby
Every business isn’t going to be profitable from the start. But, if you report multi-year losses from a business that the IRS deems a hobby, you will raise a red flag.
Especially if you also receive large amounts of income from other sources.
According to the IRS, to deduct losses, your business must operate like a business and expect to make a profit.
But, what does that really mean?
Here’s a general guideline: If a business reports a net profit in three out of five years, the IRS assumes that it is a business that expects to make a profit.
On the off chance that a business reports an overall loss in more than two out of five years, the IRS assumes the business is a hobby.
That’s pretty harsh, right?
Here’s some good news…
If you don’t meet the three-out-of-five qualification, other factors may help your case in classifying what you do as a business such as:
- large amounts of time put into the business, and
- reasonable startup expenses for your type of business
3. Claiming 100% Business Use of Your Car
Being able to deduct the business use of your car can turn out to be one of the largest tax deductions you can use to reduce your income.
The caveat to the deduction is that you can only deduct the % of expenses or mileage that apply to the business use of your vehicle.
Therefore, if you only use your car for business 40% of the time, you can only deduct 40% percent of the expenses or mileage.
So when someone claims 100% business use of a vehicle on their taxes, IRS sharks start circling.
This is especially true for those who do not own a second vehicle as it would be hard to believe you only use the vehicle for business use.
To stay on the safe side of the IRS, be sure to keep detailed records of miles driven and calendar entries for dates the car was put in use.
4. Having A Large Income
The truth is that your likelihood of an audit significantly increases as your income grows.
But, don’t take our word for it…
If we take a closer look at the about section of the IRS website we can find an article from the IRS with the title, “IRS audit rates significantly increase as income rises.”
Let’s take a look at some data to back this up.
In 2019, the IRS audited 0.4% of all individual tax returns.
For those with incomes between $200,000 and 1 million, the audit percentage doubled to 1%.
And 2.4% of people with income over 1 million were audited.
Judging by the numbers…
…it’s clear that returns reporting higher incomes are looked at a bit more closely by the IRS as the ability to benefit from large tax deductions and credits increases.
5. Overstating Your Deductions and Credits
According to the IRS, audits are triggered via computer by what they call a discriminant function test or DIF test.
The discriminant function test compares the deductions and credits you reported to similar returns and then rates your return for the potential of unreported income.
Basically, the IRS has a gauge for how many deductions and credits are typically taken at every income level.
If the deductions and credits you report don’t seem “normal”, your return will be flagged and reviewed manually.
With that being said, don’t be shy about taking every deduction and credit you deserve.
Our only recommendation is to keep good records to back them up.
6. Claiming Large Losses From Gambling
The IRS pays heavy attention to losses claimed from gambling.
This is because you can only deduct gambling losses to the extent that you report your winnings.
If you gamble recreationally and claim losses, the IRS will be looking to see if you also reported your winnings in your income.
If you claim you gamble professionally, the IRS is looking to confirm you actually gamble for a living.
If you gamble at all, be sure to report all income your receive from winning as many Casinos report your winnings to the IRS.
7. Failing to Report Stock and Cryptocurrency Gains
When you sell a security or stock for a gain, two things likely happen:
a. You jump for joy.
b. You owe taxes on the gain.
How much you owe in taxes will depend on whether you held for more than a year before you sold and if you had any losses to offset your gains.
In any case, most taxpayers must report the gain on Schedule D of their tax return.
Failure to do so will automatically cause suspicion and red flags to rise.
Luckily, most brokerages send you a tax form that outlines your losses and your gains which makes it easy for you to report.
In the instance you file your taxes and forget to report your gains, you should amend your return and refile.
8. Performing Cash Transactions
Dave Ramsey isn’t going to like this one, but performing cash transactions can raise an IRS red flag.
You might have known this but any business or trade that receives cash transactions over $10,000, must report the transaction to the IRS via form 8300.
In addition, financial institutions report on suspicious activities and attempt to avoid transaction rules to the IRS.
This level of scrutiny is a result of the IRS attempting to crack down on money laundering.
If you deal in large cash transactions, whether via your business or in your personal life, be sure to keep good records of the source of your income.
Keep Your Eyes Open For These IRS Audit Red Flags
Well, there you have it – 8 IRS audit red flags you should be aware of.
Preparing and filing taxes, especially for business owners, shouldn’t be treated lightly.
Because one single error could lead you to pay hundreds or thousands of dollars for tax penalties.
So do what you can to avoid that. And if you want to ensure your taxes are being prepared and filed accurately, you can reach out to one of our tax consultants.
We offer tax preparation services to help you this tax season.