Imagine for a second that you’ve just been notified by the IRS and they tell you that you’re being audited. Scary right? It’s not entirely out of the realm of possibility. Believe it or not, as of 2018, the odds of being an IRS audit target are 1 in 167.1 Think about what it would be like for a moment if you are one of the lucky 6% of people to receive the unwanted attention of an audit. Are you prepared?
To help give you some overall context to why audits occur and ways to avoid prompting an audit, we will list and share with you some of the most common major triggers to sidestep. We will also examine best practices on what to do when presented with an audit, as well as provide handy tips on how to avoid being in the IRS crosshairs.
Three Types of IRS Audits:
There are three types of IRS audits2 with varying degrees of severity and intensity. These are:
- Correspondence Audits -This is the least invasive type of audit. It’s when the IRS asks you to clarify a specific aspect of your return through the mail. They are typically handled by mail where the IRS will ask a specific question regarding an item or two on your tax return. This is the most common and the least invasive. Although it is by mail, it must be taken seriously. Ignoring an IRS correspondence leads to an escalation.
- In-Office Audits – For this type of audit, you are asked to appear at the IRS office to prove the accuracy of your return during an in-office audit. In-Office audits can occur with individuals as well as businesses. You are asked to appear at an IRS office with your books to be reviewed by agents. This is more severe and intense than a correspondence, but not as severe as a field audit.
- Field Audits– As the most severe of audits, agents appear on your premises to inspect your books during a field audit. Out of the three types, this one has the potential to be the most harmful to you business. Field audits are primarily reserved for business entities and it entails an IRS agent or agents appearing on-site to examine company books.
Top Ten IRS Audit Triggers
Here is a list of 10 actions both business and personal3 that may trigger the likelihood of an IRS audit. In addition to these and other triggers, you may also be selected at random for an audit:
- Excessive deductions
- Discrepancies that can be found through the IRS computer analysis mechanisms
- Significant change in earnings or losses
- Early IRA withdrawals
- Being a sole proprietors or freelancer
- Having a cash businesses
- Running a home based business
- Noticable differences between your lifestyle and income
- Unreported or overlooked income
- Sizable cash transactions without any reporting of income
Avoid Excessive Deductions
Excessive deductions for charitable contributions, as well as claiming significant mortgage interest compared to your income will raise eyebrows. Be sure to get an appraisal of donated items over $500 and make sure to use Form 8283 when submitting your tax return. Charitable deductions above $3,100 for an income between $50,000 and $100,000 is also an indicator for an audit.
Beware of IRS Computer Analysis
Algorithms known as Discriminant Information Function (DIF) are used while scanning every return for anomalies, mistakes, or deductions that seem out of place. One of the most common triggers can occur when divorced parents claim the same children as dependents. The Algorithms compare tax returns of similar income levels to look for discrepancies. Returns identified by the DIF algorithm are then reviewed by IRS staff before an audit is initiated.
Monitor your Earnings and Losses
Using excessive tax deductions to eliminate a majority of your income will more likely trigger an audit versus using deductions you are normally entitled to. Incomes over $200,000 require more complicated tax returns. The more complicated a tax return, the more likely there are to be errors that may trigger an audit. According to the IRS, incomes between $50,000 and $74,999 are the least likely to be audited.
Avoid Early IRA Withdrawals
Early IRA Withdrawals are typically an indicator of mismanaged and unreported income elsewhere. This is especially true if the return includes an improper hardship claim. Often early withdrawal penalties will not be taken which also triggers a closer look. Talk with your team of trusted professionals to include careful documentation in the event an early withdrawal cannot be avoided.
Keep Careful Records as a Sole Proprietorship or Freelancer
Excessive use of deductions compared to others in the same field can cause an audit. If your deductions are 20% or more above the average deduction of others in the same field, that will more than likely flag your return for a deeper investigation. For example, claiming your only vehicle as 100% business usage will not pass IRS scrutiny. As well, there are so many details to manage while also running a business that the likelihood of having errors is higher.
Don’t Under Report Earnings for Cash Businesses
The IRS views cash businesses and jobs such as salons, bartenders, car washes, and others as rife with potential for under-reporting. Fairly or unfairly, because cash transactions businesses have a history of under-reporting, these types of businesses and jobs are susceptible to an IRS audit.The best policy is to make sure everything is accurately reported.
Understand Home Based Business Space Allotments
According to Section 587 of the IRS Code, areas of a home-based business inside the home must be dedicated to that purpose. Not fully understanding the IRS code stipulations regarding home-based businesses will lead to common mistakes that will attract the attention of the IRS. This is a common situation that can lead to an audit.
Match your Lifestyle with your Income
Living an upper-class lifestyle while filing income taxes reflecting numbers associated with a much lower income bracket may elicit the attention of the IRS for further investigation. The IRS uses various methods to determine lifestyle, including information from friends and neighbors and even social media platforms.
Find all Unreported or Overlooked Income
Freelancers that earn more than $600 with a particular client must receive and submit a 1099 form for their earnings. Failure to report earnings above $600 will trigger a closer look with the IRS. Whether unreported or overlooked, the IRS might take notice and dig deeper to determine whether an audit is necessary.
Report the Source of Sizable Cash Transactions
If you are depositing more than $9,999 in a bank account without any context for where that money came from or reporting it as earned income, there is a strong chance you’ll get a visit from an auditor. The IRS will want to know where that money came from, especially if it wasn’t reported.
Reducing Your Chances of an Audit
To further assist you with keeping clear of audit triggers, here are some additional helpful basics to keep in mind that can further reduce your chances of being audited:
- File an electronic return
- Check return accuracy avoid math errors
- Include documentation for large deductions such as receipts, claims, or canceled checks
- Use a professional CPA
- File returns on time
- Do not omit any of your income
Best Practices when Confronted with an Audit
It’s still possible that even with the utmost care and attention to detail in your records and return filings that you could encounter an audit. If you are confronted with an audit, not all is lost. Here are a few best practices 4 that can help the process run as smoothly as possible:
- First, take a look at and understand your Taxpayer Bill of Rights5
- Ask why are you being audited
- Get professional help and use a CPA or a tax lawyer
- Take your time, and use that time to gather as much supporting evidence as possible
- Avoid giving more than what is asked for
- Clarify which year or years are being audited
- During your audit, request a recess to consult with a CPA and an attorney as needed
- Ask your audit to be conducted at an IRS office
Earlier, you started to consider and imagine what could happen if you were faced with an audit. Is it a bit less scary now? There are a lot of things you can do to steer clear of the glaring red flags that can initiate an audit process. However, if this does happen to your or your business, an audit is no time to do everything on your own. Enlist a proper professional to assist you. Be sure to be forthcoming, but there is no need to give the IRS more than what they are asking for.
An audit will most likely focus on a single year, and be sure to have the IRS clarify which year they are targeting. Exercise your rights and use your professional help to guide you through this process.
We Can Help
If you need help gathering the proper requirements, paperwork, and information for your returns,need advice on deductions, or would like to learn more about what assistance is available to you, please feel free to contact us at Gordon Law Group to learn more.