Receiving an IRS Audit Letter is every taxpayer’s worst nightmare. Just the mention of the word “audit” can bring visions of long hours with an IRS examiner, disallowed deductions, and large assessments. But in actuality, the IRS audits a small fraction of all returns. In 2019, the agency only audited 0.4% of 2018 individual tax returns and 0.7% of corporate tax returns.
When choosing which businesses to audit, the IRS uses both random selection and computerized screening techniques, which compare your return to norms established by the agency. While you cannot improve your chances of avoiding random selection, you can cut down on being filtered out by the computer screening programs if you avoid these 10 red flags:
1 – High Income – the more money you report, the more likely your return is to be chosen for an audit. Corporations earning $10 million or more were audited at much higher rates. In tax year 2018, only 0.05% of corporate returns with between $5 million and $10 million in earnings were examined, compared to 0.29% of those with earnings between $10 million to $49,999,999. The same has generally held true for individuals, except in 2019 when the group with the highest percentage of returns chosen for audit were those between $1 and $50,000. In tax year 2015, a year the IRS likes to cite as an example for typical exam rates, 8.16% of individuals with earnings over $10 million were audited.
2 – Underreporting income – if your income doesn’t match with that reported to the IRS, your return is more likely to be pulled for an audit. The IRS receives income information from third parties, such as banks and investment firms. If you exclude some of this income or miscompute your earnings compared to the IRS’s estimate based on the information it receives, your return is more likely to be audited.
3 – Schedule C – this form used by sole proprietors is often a red flag for an audit. If you use Schedule C to report your business income, be sure to include all income, correctly report deductions, and keep back-up for everything.
4 – Failing to report a foreign account – failing to report a foreign bank, investment or mutual fund account will signal an inquiry from the IRS. Failing to report such an account can lead to severe penalties. Under the Bank Secrecy Act, individual taxpayers and businesses are required to report and keep certain records for foreign bank and financial accounts.
5 – Taking the home office deduction – if you are self-employed or an independent contractor and dedicate a portion of your home for your business, you can deduct certain home expenses. While the IRS has specific rules related to the home office deduction, there’s still a lot left for interpretation.
6 – Business losses – businesses with losses year after year or ones that barely break even are a red flag for the IRS. In order for a business not to be a hobby, it has to report income in three of the most recent five operating years. Otherwise, you have to prove to the IRS that it is in fact a valid business, despite not making money. The IRS wants to ensure you didn’t set up a business just to take advantage of business deductions.
7 – Large business expenses – the IRS uses industry norms to identify businesses for audit. If your operation takes a much larger portion of business expenses compared to others with similar income or of the same type, you might be flagged for an audit. Keep detailed records of all expenses so if you are audited you can support anything questioned.
8 – Cryptocurrency – the sale or exchange of cryptocurrency, holding it as investment, or using it for the sale of goods or services, could result in a tax liability and the IRS wants to make sure individuals and businesses are appropriately accounting for these transactions. For 2020, the IRS is asking all taxpayers to answer on their Form 1040s whether at any time during the year they received, sent, sold, exchanged or otherwise acquired virtual currency.
9 – Business use of automobile – if you claim 100% use of your vehicle for business, rather than a portion for business and portion for personal, you are almost certain to be picked by the IRS for an audit. Keep detailed mileage logs of business and personal use for your automobile so you can defend yourself.
10 – Operate a business with a lot of cash transactions – cash businesses such as restaurants are more likely to be audited because of the difficulty in verifying cash revenues. If you run a cash business, keep detailed records of transactions and be sure your reported income matches your lifestyle, business size, etc. Also, any cash transactions of more than $10,000 have to be reported to the IRS on Form 8300.
We can help. If you have questions about audit red flags, or business expenses or income, contact us.