7 Red Flags That May Lead to a Tax Audit

Sorry to inform you, but you’re a prime audit target if you report multiple years of losses on Schedule C of the Form 1040, run an activity that sounds like a hobby and have lots of income from other sources. The IRS is on the hunt for taxpayers who year after year report large losses from hobby-sounding activities to help offset other income, such as wages, or business or investment earnings. The IRS usually wins in court, partly because it tends to settle cases in which it doesn’t believe it can prevail. But taxpayers have also pulled out a victory in a number of court cases. Consider including notes or an explanation with your tax filing if there are big changes in your expenses or income from year to year. “For example, if your business’s income plunged because you lost a large account, you’ll want the IRS to take that into consideration when determining whether an audit is warranted,” Hayden says.

However, there are exceptions and many taxpayers try to fit their rental activity into them in order to deduct their rental losses each year. This leads to easy pickings for the IRS, who strictly construe these exceptions — especially the real estate professional exception. The fact is that the IRS is understaffed and underfunded, which means it has to choose carefully the tax returns it audits. Here are ten of the most common factors that the IRS uses to trigger an audit.

What are the IRS audit red flags I should be worried about?

The IRS can reference data providing average charitable deductions based on various income levels. If you’re above average for your category, you might call attention to yourself. This is especially true if you’ve deducted charitable gifts of appreciated property. So make sure your donations are all properly substantiated, including by independent appraisals if required. The IRS is eyeing legal marijuana firms that take improper write-offs on their returns.

A mismatch sends up a red flag and causes the IRS computers to spit out a bill that the IRS will mail to you (these letters don’t count as audits for purposes of the IRS’s audit rate). 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. Estate tax returns tend to be audited at a higher rate than individual returns. In 2019, for example, the IRS audited 1.4% of estate tax filings, compared with just 0.2% of individual filings. “The IRS has seasoned valuation experts, and if they think the estate has valued its assets too low, an audit could be just around the corner,” Hayden says. The IRS audits small businesses and self-employed individuals more than any other category.

Reporting too many losses on a Schedule C

Writing off a Loss for a Hobby ActivityYou must report any income you earn from a hobby, and you can deduct expenses up to the level of that income. 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 the IRS establishes otherwise.

“You’re less likely to be audited in the first few years, when losses are normal and expected,” Hayden says. “Over the longer term, though, businesses are supposed to make money—and if yours doesn’t, the IRS will want to know why.” “Your federal tax return has been selected for examination.” Few pieces of correspondence evoke as much anxiety as an audit notice from the IRS. After all, not only can audits be extremely time-consuming, but they often result in interest, additional taxes, and even penalties.

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The AOTC is worth up to $2,500 per student for each of the first four years of college. It’s based on 100% of the first $2,000 spent on qualifying college expenses and 25% of the next $2,000. And 40% of the credit is refundable, meaning you get it even if you don’t owe any tax.

Math errors can happen, but if you spot them before you submit your forms, they are easily resolved. For those who want even more protection, TurboTax offers Audit Defense, which provides full representation in the event of an audit, for an additional fee. It used to be you didn’t have to report it; you just had to check a box that you had one.

Avoid an Audit by Knowing These 6 Red Flags

Battling abusive syndicated conservation easement deals is a strategic enforcement priority of the tax agency. Congress has even recently stepped in to disallow charitable deductions in the most egregious conservation easement cases. Audits then occur either by mail or in meetings at taxpayers’ places of business. Certain red flags are sure to draw scrutiny and some are easy to sidestep—unreported income, for example.

• The most difficult arguments to make with the IRS are with those taxpayers who receive a W-2 and are someone else’s employee while still claiming a substantial home office deduction for the use of their business.
• “I can’t tell you how many people just sign their professionally prepared tax returns and never even look at them,” Hayden says.
• Every business has expenses, but if you are self-employed and tempted to include a few personal expenses in with the business expenses on your Schedule C this year, don’t.
• This means that sports tickets, golfing, and other entertainment expenses are no longer deductible.

The cost of a college education continues to rise faster than the cost of inflation. The AOTC is worth up to $2,500 per student for the first four years of college. Forty percent of the credit is refundable, meaning that even if you don’t owe any tax, you get the money back. There are income limitations, and the student must be enrolled at least half-time.

Short on personnel and funding, the IRS audits less than 1% of all individual tax returns annually. We expect the audit rate to fall even lower as resources continue to shrink and even more employees are reassigned to identity theft cases. So the odds are pretty https://turbo-tax.org/top-4-red-flags-that-trigger-an-irs-audit/ 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. What is the reason for this income relationship and their respective probabilities of being audited?

When charitable deductions are disproportionately large compared with your income, it raises a red flag. That is because IRS computers know what the average charitable donation is for people at your income level. Also, if you do not 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. The IRS is intensely interested in people with https://turbo-tax.org/ offshore accounts, especially those in tax havens, and tax authorities had had success getting foreign bank accounts to disclose account information. The IRS has also used voluntary compliance programs to encourage taxpayers to disclose their foreign bank accounts in exchange of reduced penalties. Failure to report a foreign bank account can lead to severe penalties, and the IRS has made the issue a top priority.

blog December 12th, 2022

Posted In: Bookkeeping