Posted by James Financial Services Inc

Red Flags That Can Trigger an IRS Tax Audit

Red Flags That Can Trigger an IRS Tax Audit

What is an IRS audit?

The IRS may choose to examine the taxpayer's accounts and financial information to ensure that all tax laws are followed. Even though the IRS only verified 0.4% of personal income tax returns in 2019, many taxpayers live in fear that a letter from the IRS will question elements of their tax return. Taxpayers who fear being subject to an IRS audit may be reluctant to apply for all the tax incentives they are entitled to. 

The IRS typically has up to 3-years from the tax filing deadline to induct an audit or up to six years if you exclude 25% or more of your income. If you are qualified for deductions or losses and have the proper documentation to support those expenses, the taxpayer need not fear an audit, no matter how stressful it is. 

Below are some common warning signs that can trigger a tax audit and what you can do to avoid this.


Undeclared Income

Undeclared income is probably the easiest red flag to avoid and also the easiest to ignore. Any institution that distributes a person's income will report it to the IRS, and the more sources of income you possess, the harder it will be to keep track.

Old brokerage accounts are often overlooked, as are Form 1099 and distributions from college savings accounts to pay for tuition.

  • The IRS usually receives a copy of all tax forms you do, including distributed income.

  • The IRS will compare the items reported upon a person's return. If they notice something is missing, they'll automatically perform at least one letter check.


Extremely high business expenses

You can find out from the IRS if your business expenses are much higher than other businesses like yours. The IRS compares deductions made by taxpayers at the same level of income or type of business to find inconsistencies.

Keep records of your company's expenses for at least three years after the tax filing deadline, at least six years if you receive income from various sources, especially years when you have large expenses. Take steps to separate business and personal expenses. Keep a separate bank account if you are self-employed, and make sure all income is deposited and expenses paid through the business account. This way, you will have a clear financial history. Keep records such as books and calendars that document the work you have performed and receipts so that you can indicate the business purpose of your expenses. If you're paying credit card fees, it's a good idea to have a separate card for your business.

Another red signal for an audit is to ask for 100% commercial use of your car instead of dividing it between commercial and personal use. Keep a mileage log so you can estimate how long your car has been in operation and make your case if you are audited.


Violation of the rules on foreign accounts

The Foreign Accounts Tax Compliance Act provides strict reporting obligations for foreign bank accounts.

  • Foreign banks are required by law to identify owners of US assets and provide information to the IRS.

  • Individuals must report foreign assets of at least $50,000 on the new Form 8938.

There was no need to report before; you only had to check one box to indicate that you had one. Now, you need to check the box and identify the institution and the highest amount in the account from the previous year.

Regulations demand transparency, which in turn increases the likelihood of an audit. This is due to the perception that taxpayers with overseas accounts try to hide receipts overseas.

But this is a catch 22: compliance with the law increases the likelihood of an audit, and non-compliance can result in severe penalties and significant legal liability.


Hiding details on business expenses

The IRS will look closely at excessive tax deductions.

The agency uses commercial codes to measure the typical number of trips by occupation, and a tax return 20% or more above the norm may be reviewed a second time.

In addition, take-home vehicles are not considered strictly commercial, so a specific target must accompany all vehicle-related deductions.

In general, the IRS can be strict when it comes to combining personal and business expenses. Business lunches may be permitted, but exceeding the professional standard requires a remote audit. Business lunches can often be confusing, so be sure to document what is and is not a personal expense.


Home Office Deduction

Many people are afraid to deduct from their home office because they fear the write-offs will result in an audit. This can be an important break to help cover the costs of setting up and maintaining a home office. However, not all people who work from home are eligible; you can only get the home office deduction for self-employment. To be eligible, you must use part of your home "regularly and exclusively" for business purposes. Your office doesn't have to be in a separate room, but it should be in an area of your house where you can't do anything else. Space should also be your primary workplace or a place where you regularly meet with clients or patients.

You can deduct actual expenses, including a portion of mortgage interest, homeowner's or tenant's insurance, and utilities, based on the square footage of the house you use as an office. Keep track of all these expenses. Or you can deduct $5 per square foot of your home office (up to three hundred square feet) for a maximum of $1,500. If you've been self-employed for several months, you may be able to get a deduction at your home office for a partial year.


Earn over $200,000

Last year, the IRS checked about 1% of those earning less than $200,000 and nearly 4% of those earning the most, according to IRS data. Increase the limit to $1 million, and the percentage of verified tax returns will increase to 12.5%.

The same trends exist when it comes to corporate income tax returns: 1% of businesses with assets below $10 million, compared to 17.6% above this limit.

Higher income is likely to result in more complex tax returns, which may contain audit triggers. Most importantly, the IRS wants to maximize return on investment, which the agency improves each year.


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