Continued from IRS Audit Red Flags – Part Two – Common Errors
Here are a few favorite areas that the IRS has been known to target during an audit. Although most of them are unavoidable, just common knowledge of the areas that the IRS looks at should prove to be helpful.
Large changes in income
Most of these audit red flags are thought to increase your DIF score; however this is probably one of the main indicators of underreported income. There are many unexpected events in life that can cause changes in income such as a loss in job, a windfall gain, or just unexpected good or bad luck in life. As such, unexpected and significant swings in income can usually be explained fairly easily. However, large inconsistencies in income from year to year may indicate an area of concern to the IRS if the change in income is not readily apparent (i.e. losses of a job would be reflected by a W2). This is because large shifts in income can also be indicative of someone hiding income in a current or past tax year. By taking a closer look at the income earned in different years (as well as the substantiating documents), the IRS can sometimes find discrepancies in what a taxpayer earned vs. what they reported.
Large refunds/net operating losses
Generally, the IRS has no issue with small refunds because predicting the exact amount of withholdings needed over the course of the year is a difficult task, especially when factoring in deductions. However, large refunds pose an entirely different problem for the IRS and it is has nothing to do with them not wanting to write a large check to the taxpayer. First, most large refunds are not associated with standard W2 taxpayers, but rather are indicative of large losses on a taxpayer’s return or something that has offset a large amount of tax that the taxpayer would have had to pay. As a result, these issues are usually much more technical than a standard return and, therefore, the IRS will usually want to take a second look at those parts of the return to make sure you are right. The good news here is that if your calculations are right, your return will likely quickly come off the manual reviewer’s desk if there are otherwise no other problems. The same issue exists when a taxpayer shows a net operating loss that is carried over from a prior year. Because even many preparers make mistakes when reporting net operating losses on a client’s return, the IRS is likely going to examine this section of the return due to the potential high margin of error.
Foreign bank accounts, income from foreign trusts, frequent cross border transactions
Even though taxpayers may have perfectly legitimate reasons for engaging in cross border transactions or may own property in other countries, such activities traditionally make the IRS nervous for a variety of reasons. First and foremost, IRS summons authority and the ability of the IRS to demand records from 3rd parties (banks, financial institutions) in foreign countries is extremely limited. Particularly in those countries with strong bank secrecy laws, the IRS may not necessarily ever find out about the existence of these assets unless they are voluntarily disclosed by the taxpayer. Furthermore, cross-border transactions and hiding assets and foreign countries are often used method to evade taxes. As such, the IRS has now requires taxpayers to disclose if they have foreign assets on their tax returns (and can seek prosecution if they lie about it) and is particularly cautious of taxpayers that do. Although the IRS will audit not everyone who has assets or transacts business internationally, your risk of audit may increase if you do. It should also be noted that the IRS has generally increased enforcement efforts against businesses with locations right on the US/Mexico border, particularly those that may deal with large amounts of cash. If you do operate one of these businesses, you should be informed that these businesses can and frequently do get audited.
Returns where the individual admits they are participating in a tax shelter or listed transaction
Yeah, that one is easy.
Continue to IRS Audit Red Flags – Part Four – Cash