This chapter is devoted entirely on the discussion of tax audit red flags and how to avoid them.
Once a return is selected for audit, the level of scrutiny and leniency are all depending on the IRS agent’s and his manager’s working style. Some agents and managers will make sure no stones are left unturned. Others can be very pragmatic. It’s also very important for your CPA to manage and maintain a good the relationship with the agent. I had the pleasure to work with a nice agent and manager during a recently concluded IRS audit in which I helped negotiated a “no change” on a number of glaring mistakes.
The red flags I listed here are not in any particular order of riskiness. Let’s take a look.
- Hiding a foreign bank account in the Swiss alps? Good luck with that. The IRS has ramped up a great deal of effort in recent years to bring folks back into the compliance fold. There are two reporting requirements (the $10,000 rule and the $50,000 rule) related to foreign assets and the penalty can easily wipe away all of your oversea savings.
- Divorced ex-spouses report a different amount of alimony paid (deductible expense) and received (taxable income). This mismatch can be easily caught by the IRS computer system. Guess which spouse will be the lucky one to explain the mishap to the IRS? It’s the payor spouse who got the deduction in the first place.
- An unreported income on a Form 1099 can come back to haunt you a few years down the road. This could be a slot machine winning, a prize or award you won, or a small consulting job you did for a company. Sometimes people simply forget about it, and sometimes it is the payor’s mistakes (late filing, filed with mistakes…etc). Either way, once the form is reported to the IRS, you are on the hook to report it.
- If you buy and sell ETFs, stocks, mutual funds and the like, be sure to obtain Form 1099-B from your brokerage firms and report all relevant items on your tax return. Easily missed and buried deep inside the many pages of Form 1099-B are the Form 1099-INT (interest income), Form 1099-DIV (dividend and capital gain) and foreign tax credits. Please do spend some time to review the entire deck of Form 1099-B.
- You will receive a Form 1099-K (Payment Card and Third Party Network Transactions) if you collect or receive money via a third party network such as Paypal. Be sure to include these money in your annual income tally because the IRS also receives the same information from Paypal.
- Schedule C filed by sole proprietors, aka self-employed individuals, tends to have a higher risk of getting audited. Simply forming a corporation or an LLC will help provide stability and peace of mind for many years to come.
- Schedule C filed by single-member LLC (SMLLC). Many states, including California, allow an LLC to be formed with only one member (one partner). For federal income tax purposes, this single-member LLC is disregarded, and therefore it must report its income and expense on the member’s tax return. In my practice I always recommend forming an LLC with at least two members so that the LLC will file its own separate tax returns like it is supposed to be and the audit risk is reduced substantially.
- Because the IRS system looks at the overall reasonableness of a tax return, reporting a higher or lower income, in itself, does not necessarily trigger an audit. However, by auditing high income tax returns ($1 million or more), it is more likely that the IRS can get back a sizable chunk of additional taxes, interests and penalties that are worth the cost and time to pursue the audit. For the same reasons, low income tax return ($200,000 or less) are generally thought to be safer. But remember that these are not magic numbers. Everything reported on the tax return must be reasonable.
- Unreasonable and/or uncommon deductions will always get the IRS’ attention. This tax return, for example, will most likely be audited: a greedy taxpayer brings a $450,000 gross income down to a $3,000 loss. One might say “What’s the big deal? The IRS fuzzes over a small $3,000 loss?” One is better served to really look into the $480,000 deductions you need to bring an income of $450,000 down to a $3,000 loss. Are those deductions reasonable? My rule of thumb over the years is this: report a reasonable profit, pay a fair share of taxes, and you can go enjoy your vacation stress-free.
- If an S Corporation is generating profit, the shareholder/employee who works for the corporation must issue himself a reasonable amount of payroll and pay payroll taxes accordingly. Failure to do so could cause a very nasty and costly audit.
- Payroll report mismatch. You will receive correspondence letters if there is a difference between the payroll amounts reported to the IRS and the social security administration (SSA).
- Early withdraw from IRAs and 401(k) plans can easily be mishandled and thus become the target for audit. Remember that a 10% early withdraw penalty applies unless you fall into one of the exceptions.
- Treating your employees as subcontractors (thus you avoid paying payroll taxes) can save you a lot of money in the short run but it can also cost you a very expensive audit later on. So please do not short change the employees for your own benefits. Do the right thing and you will sleep better at night.
- A popular deduction (and abuse) for self-employed individuals and employees are Business Use of Home deduction. You can either report the actual costs that come with a higher audit risk, or use a simplified safe harbor method (deduct up to $1,500 per year). I highly recommend the latter because it is a lot easier to claim and substantiate.
- Unusually large charitable contribution that does not resonate with your level of income. If your cash donation is legitimate, make sure you get a contemporaneous acknowledgment from the donee organization. If you donate an expensive piece of property instead of cash, it’s best to have an appraisal report to back up the fair market value that you claim. Also remember that the value of your time (spent on volunteer events, for example) is never deductible as charitable contribution.
- Rental losses are also red flags if not claimed properly. If you actively participate in the renting of your house, the requirements that most taxpayers can satisfy, you can usually claim up to $25,000 of rental loss. An actual real estate professional, however, can claim more losses, and thus become the source of abuse.
- Excessive hobby losses are never allowed. You are supposed to deduct hobby losses up to the hobby income you generated. To get out of the hobby classification and deduct more losses, your business must be run and managed with the intention to make a profit. When certain conditions are met, the IRS will assume you are in the business to make a profit.
- R stands for “Rounded Numbers”. These are not illegal by themselves. You might have one or two legitimate round numbers on your tax return that you have backup documentation to prove it. Having too many rounded numbers are usually indicative of using fake numbers.
- Is it really true that you use a car for business purposes 100% of the time (and thus getting maximum depreciation expense) when that’s the only car you have? You know the answer. It’s a lot easier to lease a car using the company as the lessee.
- Inconsistency on the tax return is a common mistake that can easily be overlooked. For example, you claim, as education expense deduction, the cost of a computer programming class at a community college but you put down your occupation as “business analyst” on the first page of Form 1040. This inconsistency will render the education expense non-deductible as it is not related to your profession of being a business analyst.
- Failure to report the sale of your primary residence could trigger a correspondence audit. This is because the IRS will receive a Form 1099-S after the sale. Even if you qualify for the homeowner’s exclusion of gain, it is still a good practice to report the sale.
- Conflict in claiming dependent child(ren) will surely invite the IRS. Parents should be in agreement as to who will claim which child(ren). Unless agreed otherwise, the parent who have higher AGI or live with the child(ren) longer will get to claim the dependency.
- If you are married but choose to file tax returns separately, you must check with the other spouse whether he/she claim the standard deduction or itemized deduction. If one of you claims the itemized deduction, the other spouse must also claim the itemized deduction.
- Do not amend a previously filed married filing jointly return to a new pair of separate returns. This is not allowed and the IRS will come looking for you. However, you can amend a separate return to be a joint return.
- Failure to report advance premium tax credit, shown on Form 1095-A, will invite a correspondence from the IRS. You must report any advance premium tax credit (aka Obamacare subsidy, Obamacare tax credit) you received throughout the year to reconcile with the actual credit amount that you are entitled to.
- Extravagant deductions of meal, entertainment and travel expenses must be avoided. To be deductible, these expenses must be for business purposes. The idea is very simple but there are a lot of abuses.
A tax audit engagement is a very expensive and time consuming proposition for you and the IRS. Not to mention the anxiety and the loss of sleep that come with it. Most CPAs and attorneys will ask for a big chunk of retainer up front. The total cost can add up very quickly because our prices are generally charged based on billable hourly rate.
To read a full-blown official version of all things related to an IRS examination, please visit this IRS webstie:
Jimmy W. Wong, CPA left the comfort and stability of Corporate America and started his own consulting firm with a true passion to help business owners succeed in their endeavors. He is a certified public accountant, an IRS enrolled agent, and a member of the American Institute of CPAs.
Jimmy graduated from California State Polytechnic University Pomona with a Bachelor’s Degree in Accounting. He is currently studying for a Master’s Degree in Business Taxation at the University of Southern California.