It is common knowledge that the IRS audits a very small percentage of tax filers – less than 1% - but audits are spread unevenly among income groups. The IRS has limited resources, so it prioritizes where it spends them. Naturally, the IRS directs most of its resources towards larger earners. According to the IRS, it audits 8.2% of taxpayers with incomes above $10 million, 2.5% of those with incomes between $1 million and $10 million, and less than 1% for incomes below $1 million. This data is a little outdated though, as it is for the year 2015, the last year for which the IRS has complete data.
Despite the low audit rates, there are several factors that may increase a taxpayer’s risk of being audited. These “red flags” can put you in the IRS’s crosshairs and trigger the dreaded audit. Below are red flags to avoid to minimize the risk of an audit. No one likes to be audited, even if they believe their tax affairs are in tip-top shape. Avoiding these situations can lower your chances of being audited.
Having Income and Not Filing a Return
If you have income and did not file a return, the IRS can come after you to get you to file and pay your taxes. The IRS can use punitive measures to get you to comply, including penalties, fines and even court action (both civil and criminal). Remember the IRS has copies of your W-2s and 1099s, and stockbrokers report certain investment gains and losses to the IRS. Not filing your tax return is never a good way to avoid paying taxes.
One of the most obvious audit triggers is excluding income from your tax return. Employers file 1099s and W-2s with the IRS, so leaving income off your tax returns is not a good idea and greatly increases your chances of being audited.
Deductions that are out of line with your income sources and income level may appear suspicious and trigger an audit. If you operate an auto shop and have large business meal deductions, this might appear suspicious, as an auto repair operator isn’t likely to be having regular business meals with customers. Always make sure there is adequate documentation for deductions to avoid a tax bill if you are audited. And remember that entertainment expenses are no longer deductible.
Deductions that are above average for an income level may appear suspicious to the IRS and trigger an audit.
Having business income on Schedule C puts you on the IRS’s radar for an audit. There are many rules around the types of expenses that can be deducted from business income. Many people (intentionally and unintentionally) claim expenses that aren’t allowed. Some business owners who collect a lot of cash may be tempted to under-report their incomes. Operating a cash-intensive business increases the risk of being audited.
Home Office Deduction
The home office deduction is ripe for manipulation, from taxpayers inflating the square footage to pandemic-induced work-from-home employees mistakenly claiming the deduction. Many people have been asking if they can claim home office deductions for working from home. The answer is no. If you have W-2 wages and claims home the office deduction, you increase the risk of an audit.
Motor Vehicle Deductions
Do not put on your tax returns that your vehicle is used 100% for business and you have no other vehicle available for personal use. You might be putting yourself in the IRS’s crosshairs. Also, claiming business miles that seem excessive for your line of business may trigger an audit. A virtual accountant working from home is unlikely to have many business miles, and one claiming excessive business miles may be ripe for an audit.
Reporting Trading Losses on Schedule C
Persons who make a living as a trader can deduct their trading expenses on Schedule C. An investor is not allowed to do so. Traders can also deduct losses above the $3,000 threshold set for ordinary investors. A taxpayer must meet the definition of trader to claim these expenses. A trader is someone who trades frequently and hopes to make a profit off short-term market movements. Investors focus on long-term dividends and capital gains and aren’t doing frequent trades. Making few trades and claiming trading expenses and losses could lead to IRS scrutiny.
Marijuana businesses are magnets for IRS audits, because they cannot take certain business write-offs at the federal level, as marijuana is still illegal under federal law. The IRS scrutinizes marijuana companies to ensure they’re not claiming unallowed expenses.
Gambling Winnings and Losses
The IRS doesn’t care too much how you earn your money. They just want theirs. If you have gambling winnings, you must report them. Depending on your winnings, a casino might report them to the IRS. Failing to file a return when winnings have been reported can get you in trouble with the IRS.
Gamblers might want to deduct losses but not report winnings. However, losses can only be deducted to the extent there are winnings. If you’re reporting large losses and no winnings, you might invite a visit from the IRS.
Not Reporting Cryptocurrency Gains
Many people trading cryptocurrencies have not been reporting their gains to the IRS. Taxpayers are now being forced to fess up to their crypto trading, as the IRS has a question on Form 1040 asking taxpayers whether they engaged in cryptocurrency trading. It will be a huge red flag if a taxpayer answers yes to this question but report no crypto gains or losses.
The IRS also has asked crypto exchanges such as Coinbase for information on cryptocurrency account holders and is mailing letters to suspected crypto traders. It is becoming more difficult for crypto traders to escape the tax dragnet, and those owning crypto assets and avoiding taxes could soon get a visit from the tax man.
Engaging in large cash transactions could elevate audit risk. Banks and casinos report large cash transactions to the IRS. Such transactions could put you on the IRS’s radar.
Claiming Charitable Donations
Claiming excessive charitable deductions is a red flag for the IRS. Make sure you retain appropriate documentation for your charitable contributions.