We are smack in the middle of tax season again as everyone is trying to meet the April 15th deadline. Many dread the prospect of an IRS audit so getting all the information correctly coded on the tax forms is of course a high priority. No one wants to worry about the IRS knocking on their door (which I don’t think they initially do, opting instead for the conventional letter in the mail).
The unfortunate reality is that there is no silver bullet to avoiding an IRS audit. The IRS can choose to investigate and audit anyone they please at any time. Even low-income earners can be subject to an audit if the IRS becomes suspicious.
What would make them suspicious? Well there are a variety of factors, red flags if you will, that can make an IRS agent question a tax return. Some of them can’t even be avoided. But what can be avoided with all of them is the worry. If you are handling things correctly there is no need to worry about any of these situations.
Common Red Flags That Might Trigger an IRS Audit
While this is not an all-inclusive list, these represent common issues that might pop up as a red flag to the IRS:
1. Your income is over $200,000 a year.
Yes, it’s true. High-income earners have a higher chance of facing an audit. It’s a significantly higher chance according to data published by the IRS.
This really shouldn’t surprise anyone. The government has the most to gain by going after the wealthy. And the wealthy have more to gain by fudging numbers on their tax return. So it’s a match made in audit heaven.
How to avoid the worry: Accept the scrutiny that comes with being a high-income earner and move on.
The only thing you can legally do to not earn as much income is to not earn the income. You’d have to move (downgrade) to a less high paying career. Be thankful you are a rockstar when it comes to making money and get on with your life. You should never worry that you’ve been blessed with or developed the skills to have a high paying career.
2. Not reporting taxable income, including cash.
The IRS requires you report the amount of income you earned exactly as your employer paid it out to you. As a business, your employer has to report what you’ve been paid. If there is a discrepancy because it doesn’t match what you’ve put on your return then watch out. That’s an easy one for the IRS to spot.
Furthermore, if you work in an industry where the income could be received as cash your likelihood of an audit increases. I guess the IRS simply assumes you will cheat because cash income is easier to hide.
How to avoid the worry: Be honest…Report all your income!
I’m like the rest of you…I’d like to keep as much of the money I earn as anyone else. Though it would be tempting to hide my income (especially cash income) from the IRS, for me it’s an integrity issue. We have a system that requires I pay taxes. I feel it’s my moral and ethical obligation to do so. If you don’t feel that way then you are simply inviting an audit.
3. You give a lot of money to charity.
I guess this red flag would fall under the category of “anomalous behavior.” It wouldn’t raise a red flag if someone making $300,000 a year donated $50,000 of that to charity. Reverse those numbers and it would really stand out if the tax return showed someone claiming $50,000 in income and $300,000 in donations.
How to avoid the worry: Report all your income properly (see #2) and give as much as you want anyway.
The IRS shouldn’t be in your head about how much you give to charity. That’s a personal decision your family makes out of the desire to bless others. Don’t base your giving decisions out of fear that it might trigger an audit. You’ll be tempted to give less than you are able and others will miss out on the blessings your donations provide.
4. Claiming the home/office deduction.
According to the IRS, there are two basic requirements for your home to qualify as a deduction:
- You must show regular and exclusive use. In other words, you must demonstrate that you use a part of your home (i.e. a room) exclusively for conducting business (meaning you can’t claim your bedroom as an office if it contains a computer that you work at),
- It must be the principal place of your business. Business can be conducted elsewhere but not at a greater percentage than how much is conducted within the home.
As I guess you are probably thinking, this deduction is WAY open for abuse. Again who’s to know how you are using the rooms in your home? The IRS would have a hard time figuring out that the “office” I’m working at right now is taking up 1/3 of my living room.
How to avoid the worry: The easiest way to not worry about this red flag is not to claim it. In a lot of cases it won’t make much of a difference on your taxes anyway.
If you insist on claiming it as a deduction, make sure to accurately figure out the percentage of your home devoted to business use. Take pictures to document the area if you have to.
5. Claiming 100% use of a business vehicle.
This is similar to the home/office deduction. If you use a car for business, the IRS says you may deduct all the expenses used to operate and maintain that vehicle, up to certain limits. If the car is for business and personal use, you are only able to claim expenses incurred while using it for business.
Of course, if you only had one car how could you claim 100% use of it as a business vehicle? All those trips to the grocery store, gym or church are really business expenses? You can see why this red flag might get the IRS’s attention.
How to avoid the worry: Customize vehicle use and keep accurate records.
The easiest thing to do here is use a separate vehicle if that’s possible. Use one vehicle for business and another one for pleasure.
If that’s not possible and the vehicle is used for both, then you will have to keep accurate records of whether the expense resulted from business or personal use. This may include keeping a log book in the vehicle or using apps to record mileage accumulated during your business travels.
6. Writing off a loss for a hobby.
The IRS regulations differentiating a business and hobby are a real gray area. While there are many factors a taxpayer should consider, the IRS allows taxpayers to…
“…deduct ordinary and necessary expenses for conducting a trade or business. An ordinary expense is an expense that is common and accepted in the taxpayer’s trade or business. A necessary expense is one that is appropriate for the business.”
The IRS believes an activity qualifies as a business activity if it is conducted with the reasonable expectation to make a profit. If the activity is not for profit, then financial losses cannot be used to offset other income.
So the money you are losing by trading baseball cards or raising horses for family use cannot be claimed as a deduction.
How to avoid the worry: Enjoy your hobbies, even if they cost you money.
Hobbies are for our enjoyment. You will have to decide what it is you are trying to accomplish with your hobby.
If you want it to turn into a business, that’s fine. I know many bloggers who started out as a hobby and have now gone full-time with it as a business. There’s a fine dividing line on when that happens though, so make sure you understand the rules.
7. Data entry mistakes
Mistakes on the tax form can easily happen when you are working late at night in TurboTax. Forgetting to add a zero could mean the difference between a five and six figure income. But it’s not just retail investors who make mistakes on tax returns. Professional preparers – yes, even CPAs can code something wrong onto a return.
No matter how or where the error originated you, as the taxpayer, are legally responsible. If you have a quality CPA firm, they will admit their mistake, help you get it corrected and pay for any fines you incur. But the burden of proof always lies on you to prove to the IRS it was unintentional.
How to avoid the worry: Double check and do the best you can.
Nobody is perfect. All you can do when filling out your return is to do the best you can. Double check over the answers even if a professional does your tax return. If anything seems odd, question it.
Then sleep well at night knowing you’ve done the best you can. If an issue arises, deal with it when it comes.
How to Really Avoid the Worry of An IRS Audit
There are certainly other issues that raise an IRS red flag. However, there are two fundamental themes woven through all these that I’ve mentioned plus the other red flags that are out there. If you practice these year in and year out you will never have to worry about an IRS audit.
The two big keys that will help you sleep at night are:
- Record keeping
If you are honestly filling out your tax forms the best way you know how and are keeping solid records to support what you put down on the form then you should never worry. It may still frustrate you off if the IRS comes knocking on your door but at least you can enter the audit process with proof and a clear conscience knowing you have nothing to hide.
Questions: What other IRS audit red flags are you aware of? Have you ever been audited? If so, how did it go? Do you think it’s right the IRS targets high-income earners?