IRS Audit Red Flags – Part Three
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 of 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 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 is that if your calculations are right, your return may come off the manual reviewer’s desk in a short time, barring 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 may examine this section of it due to the potentially high margin of error.
Foreign Bank Accounts, Income From Foreign Trust, 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, the IRS summons authority and the ability of the IRS to demand records from third parties (banks, financial institutions) in foreign countries is extremely limited. Particularly in countries with strong bank secrecy laws. The IRS may not find out about the existence of these assets unless they are voluntarily disclosed by the taxpayer.
Furthermore, cross-border transactions and hiding assets in foreign countries are often used methods to evade taxes. As such, the IRS now requires taxpayers to disclose if they have foreign assets on their tax returns.
They can seek prosecution if a taxpayer lies about it and is particularly cautious of US persons that do. Although the IRS will not audit everyone who has assets or transacts business internationally, your risk of an audit may increase if you do.
It should also be noted that the IRS has 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 a business like this, there is an excellent chance you will get audited.
Returns Where The Individual Admits They Are Participating in a Tax Shelter or Listed Transaction
Yeah, that one is easy.
IRS Audit Red Flags – Part Four
Cash is a major audit red flag because it creates all sorts of problems for the IRS. It is almost impossible to track cash transactions, can be easily hidden, does not have a clear electronic record to keep track of it, and is difficult for the IRS to verify.
One of the big fights that the IRS has been waging for years has been against cash businesses. Hospitality workers who do not report their tips, taxi drivers who collect off-meter fares, retail store owners who sell merchandise off-book, etc.
Cash transactions go unreported by a great many taxpayers, many of whom believe that they do not have to report the cash (wrong) or who figure that the IRS will never know that the taxpayer received cash.
Specifically, the IRS targets returns where taxpayers may deal with large amounts of cash and consider it an audit red flag when a return contains a high probability of unreported income. The IRS does this by looking for these three methods of fraud:
- Skimming – taking cash from a business prior to it being recorded as a sale. For example, a clerk in a store who does not ring up a transaction and pockets the cash.
- Embezzlement – taking cash after a sale has been recorded. For example, a clerk in a store who takes money out of the cash register.
- Fraudulent Transfers – A transfer of funds listed as an expense when it actually should be recorded as income. For example, a payment listed as being to a vendor that is actually taken by an owner or employee.
These examples illustrate methods that taxpayers who deal with lots of cash use to cheat the IRS. They should provide you with a rough idea for the types of things the IRS is looking for when they audit a cash return.
As a result, taxpayers who frequently deal in cash will likely receive increased scrutiny by the IRS.
This audit red flag is raised when the IRS identifies these taxpayers by looking at the occupation code that they indicated when filing their tax return. What the taxpayer lists as their occupation on page two of the tax return is also determined. Returns that have a high likelihood of unreported income or fraud will likely then be subject to audit.
Another audit red flag related to cash (and one that the IRS has been targeting) is the taxpayer who makes cash transactions in excess of ten thousand dollars. Banks and other financial institutions are required to fill out currency transaction reports (CTRs) when an individual pays, deposits, or otherwise utilizes over ten thousand in cash.
In addition, those who deposit lesser amounts to try and avoid the CTR (which is called structuring and is illegal) or who otherwise participate in a suspect activity risk having a suspicious activity report (SFR) filed against them.
It is not entirely clear how much these items affect a person’s audit risk. However, it is clear that these documents are reported to and kept track of by the IRS.
IRS Audit Red Flags – Part Five
Inflated charitable contributions are one of the most abused tax deductions and, as such, one of the biggest red flags that a return is deserving of an audit.
In addition, many taxpayers fail to include the required schedule for non-cash contributions to charities, which is indicative of either a false deduction or the fact that the taxpayer lacks the proper substantiation requirements under the Internal Revenue Code (resulting in a disallowed deduction).
In any event, the IRS often challenges non-cash charitable contributions because there is at least some potential for change and resulting in additional revenue for the IRS.
This is not a huge red flag for everyone. As you get older in age, the IRS likely becomes more tolerant of medical expense deductions and, therefore, would be less likely to select you for examination based on this category alone.
However, medical expenses are frequently abused by some on the form or another by taxpayers trying to write off cosmetic and other aesthetic procedures as legitimate medical expenses.
In addition, medical travel has been a huge potential area for abuse as some taxpayers game the system to try and absorb some of their personal travel costs.
One of the biggest telltale signals of potential abuse is when medical expenses (or Schedule A expenses in general) rise as income rises or there is significant medical expense for someone who is younger and does not have a history of high medical expense deductions.
Again, many taxpayers are entitled to and legitimately have high medical expenses. However, like most other Schedule A deductions, there is often great potential for abuse.
Losses from Rental Property/Complex Rental Income and Expenses
Rental property has been a particular subject for abuse in recent years with the dramatic changes in the housing market. As such, many people have been unscrupulously padding losses into their investment properties to help offset income from other sources.
This happens frequently with those who have portfolios with multiple properties and who may be unfairly using losses to offset large gains. In some cases, these losses can be fairly substantial and result in a significant tax loss to the government.
Rental property losses in the first year or even the first few years will not necessarily trigger an audit, particularly because of the illiquidity in the housing market, but sustained losses draw scrutiny from the IRS.
Think of it this way – why would someone continue to dump money into a losing investment year after year for a purpose other than to generate a tax loss (i.e. no significant business reason)?
Also, abnormal losses for a certain year may also raise a red flag particularly with frequently abused/misreported expense categories such as repairs and maintenance (the IRS will audit you for capital expenditure treatment).
IRS Audit Red Flags – Part Six
Unreimbursed Employee Expenses
Unreimbursed employee expenses are perceived to be one of the most common IRS red flags. The IRS frequently reviews unreimbursed employee expenses in audits, as they are widely considered a high abuse category for W2 employees.
As a practitioner, when reviewing an audit client’s tax return, I often do a quick calculation to determine what percentage of adjusted gross income (AGI) do unreimbursed employee expenses total. Anything over five percent (5%) and I make sure to ask my client about the nature of the expenses taken.
Think of it this way – an employer is not likely to pay you a salary only to turn around and make you spend more than five percent (5%) of it on the cost to do your job. If that is the case, these expenses are usually reimbursable to the employee by their employer.
The problem with unreimbursed employee expenses is that many people either throw personal use expenses into this category or add things that are not tax deductible (like dry cleaning expense).
The IRS is catching on quick, however. Not only do they monitor your total Schedule A expense (as a percentage of income), but they compare it to others who have your occupation and flag the outliers for additional screening.
Given the history of abuse associated with this category, it is important to be vigilant when totaling your expenses to make sure they meet the requirements of the Internal Revenue Code. Be prepared for the government to take a look at these expenses, as they are one of the common IRS red flags.
Home Office Deductions for Businesses That Are Not Run From The Home
If I were asked to name three IRS red flags where I saw clients get challenged and usually resulted in a change, this category might top my list.
Home office deductions and the associated expenses for individuals whose company has a primary location somewhere else tends to trap taxpayers who are not completely familiar with the nuances of the code. Many people misinterpret the rules associated with the deduction while others simply abuse or try and game the system.
The most difficult arguments to make with the IRS are with those taxpayers who receive a W-2 and are someone else’s employee while still claiming a substantial home office deduction for the use of their business.
It is really hard to make an argument, absent special circumstances, that an employer either does not provide a suitable primary office location for the employee’s position or does not reimburse them for the out-of-pocket-costs associated with setting up a home office.
Furthermore, some occupations statistically do not normally require home offices. It therefore seems obvious that IRS red flags may be raised when you are in one of these professions and claim a home office deduction on your tax return.
Just be careful when claiming the deduction and always keep good records (including photos of the office environment). If you claim the deduction, know that you are likely increasing your chances of an audit and be prepared for a potential uphill battle.
IRS Audit Red Flags – Part Seven
Claim Business Meals, Entertainment and Travel Expenses
This one is probably a close second on the categories that are challenged by the IRS as meals, entertainment, and travel (MET) deductions are one of the most frequently used and abused deductions.
As such, high MET deductions, especially when not supported by substantial business revenue to justify the expense, will likely increase your risk of an IRS audit.
Risk of an Audit
First, there is an extremely thin line between what an allowable business expense is and what is not. The test under the Internal Revenue Code is an expense that is both ordinary and necessary in the line of business.
Ordinary and necessary under the Code are two separate requirements and are terms of art among practitioners. This means that what is ordinary and necessary for one profession may not be ordinary and necessary for another and subject the latter to an IRS audit.
Auditors frequently challenge the “necessity” of entertainment expenses and often win (categories that result in a high percentage of changes usually get challenged).
In addition, many people mistakenly believe they can write off all expenses associated with travel or with entertainment if it is business-related.
I have often found in my experience that meal/entertainment/travel expenses are one of the categories that taxpayers are least likely to be able to substantiate. Taxpayers either:
Think logically about meals/entertainment/travel and the profession that your expenses are associated with. Very few professions require international travel or substantial meals and entertainment expenses.
Mileage and other car and truck expenses
We should start with the bad news.
If I could pick one area where my clients frequently fail to provide proper substantiation, it would be business miles. Revenue agents (and the code) require documentation in the form of a mileage log, but I have known very few people who actually log mileage.
The worst part is because so few taxpayers keep proper mileage documentation then they usually estimate this category by using (you guessed it) numbers that end in a few zeros. The IRS has been onto mileage for years and it is one of the areas I see targeted most in an audit.
Major vehicle expenses (absent a profession that requires frequent travel) are a big target for the IRS.
However, the good news is that is where the bad news stops.
Revenue agents will use the internet to confirm business locations, but other than a few isolated instances I have not seen too many challenge your expenses much further.
Professions with high mileage
Those professions with natural high mileage (truck drivers, real estate agents, and sales people) are also usually less likely to face strict scrutiny. Furthermore, unless the expenses appear excessive, I have not seen too many people audited solely on mileage or business use of vehicles alone.
This is most likely because many taxpayers have professions that require driving of some sort, and the IRS, absent any other audit red flags, just does not have enough resources to check everyone’s mileage log.
Just be careful when writing off car/truck expenses and mileage and, if it appears to be excessive for your profession, make sure to record a mileage log as reconstructing one later can be challenging.
IRS Audit Red Flags – Part Eight
Small Business / Schedule C Losses
Many of my frustrated, wage earning, tax preparation clients ask me all the time if they can lower their tax liability by starting a “business” and deducting their expenses. I caution against this idea for several reasons.
For starters, most taxpayers fail to consider the material participation requirement when launching their new business. As such, they deduct income that should be characterized as a passive loss against active income and get nailed by the IRS in an audit.
Think about it: How many people do you know with full time jobs that spend 750 hours or more in another business? Probably not too many.
In addition, side businesses that show losses in multiple years are subject to review for actual profit motivation under the hobby loss rules, which the IRS can and does audit regularly.
Just because you love making arts and crafts projects in the garage or enjoy racing cars on the weekend does not mean that you are engaging in these activities with the motivation of making a profit.
The IRS knows this and your DIF score may increase, especially with a side business with an element of fun in them (travel writer, beer/wine making, horse racing, any sort of professional gambling, etc…).
The IRS has been onto this trick for several years now and will audit businesses that show losses or that have the appearance of trying to off-set legitimate tax liability.
Stock Trades and Complex Schedule D & B Transactions
I hate to say there is a bias against those who trade stock, but frequent stock trading has a very high margin of reporting error and might earn you a review of your tax return by the IRS.
There is nothing wrong with frequent trading and a good tax preparer can actually make the reporting pretty straight forward (many brokerages have gotten a lot better with the information contained in their statements.
However, because of the complexity that occurs from some transactions or the difficulty in properly calculating basis for stock trades (and therefore appropriate gain and loss), the IRS sometimes will want to take a second look at your return to make sure this has been done accurately.
However, these issues are often time consuming and difficult, so I personally have not seen too many returns subjected to an IRS audit on the basis of stock trading alone unless there is a mistake on the return.
A word to the wise for traders though. I hope that if you are dealing in frequent trades or asset sales that you have a tax attorney, CPA, or someone else knowledgeable enough to prepare your returns.
Although mistakes can and do happen, they are significantly reduced when you hire a preparer comparable to the level of sophistication of the tax return. In most cases, if you follow this rule, you should be fine.
However, make sure (especially in this instance) to save all documentation relating to any stock trades or the sales of that asset – especially how you valued it. This will make or break you should you have to undergo an IRS audit.
IRS Audit Red Flags – Part Nine
As you have probably learned by now, the IRS is an organization that is heavily reliant on statistics. The Service has a limited amount of resources and must therefore pursue only those avenues that are the most effective for increasing tax revenue.
Tax returns are a treasure trove of information though, and the Service has become increasingly sophisticated at utilizing this information to make itself more effective. This is not just limited to individual taxpayers, but also groups of taxpayers who live in the same area or who have similar jobs in similar industries.
It collects enough statistical data to come up with median figures or ranges of where it expects taxpayers to be in certain categories and audits those who are outliers.
For example, let’s say the median income for a household in Beverly Hills, California was $200,000 per resident. If you are a taxpayer that filed a tax return claiming only $50,000 in income, it would be safe to assume that you might attract the attention of the IRS.
Similarly, a taxpayer who made tens of thousands more than the median income in a given area would also likely arouse suspicion within the IRS. The same reasoning also holds true with taxpayers in similar industries.
Plumbers making hundreds of thousands of dollars or CEOs pulling in just over minimum wage will also likely be subject to audit. Certain professions also carry higher audit risk than others.
Audit Technique Guides published by the IRS can also provide some clues as to what the IRS views at professions with a higher proclivity for abuse.
The IRS also uses statistics to look for likely IRS audit red flags with businesses by comparing their margins. As an attorney, one of the first things that I look for when a small business owner approaches me about representing their business in an audit is what their margin percentages are.
Gross Margin Percentage = (Revenue – Cost of Goods Sold) / Revenue
Net Margin Percentage = Net Profit / Revenue
There is not a magic number for what your margins need to be. Every business is run differently and will have different margin percentages based on their annual revenue and their expenses.
However, even though businesses will all vary on their margin percentages, margin percentages for a particular sector among similar businesses will largely be within a certain range.
The IRS knows this and IRS audit red flags may be raised for businesses that are outliers, either with margins that are too low or too high. For your own edifice on what traditional margins are for your industry, there are many sources online that will tell you.
Let me show you how margins can work against you on your tax return. Say I own Convenience Store A. I file a tax return indicating that I made a 10% percent profit from the store after my expenses. No problem there. Now let’s say that Convenience Stores B, C, D, E, F, and G all file tax returns showing a 30-35% profit. That is quite a step up from 10% profit.
There are several possible explanations here. I could be a bad businessperson. My revenue might be the same as these stores, but perhaps I am not keeping my expenses or my cost of goods sold in check.
Consequently, I could have the same expenses and show less revenue because of a loss of business. Both of those are perfectly logical explanations. However, if I am not keeping up with my competitors, I am likely not going to stay in business for very long.
I could also be skimming cash from the registers and underreporting income (decreasing my revenue) or inflating my cost of goods sold (reducing taxable profit) or inflating my operating expenses (also reducing taxable profit).
In contrast, if I start showing 75% profit, I am either the world’s greatest convenience store operator or there is a serious impropriety with my business.
My point is that you operate in the audit danger zone if you are outside the generally accepted range for businesses that are similar to yours. Tax cheaters will often try and bury deductions into other expense categories to not make them stand out or will make sure there is no paper record of them taking money out of the cash register.
However, if they go too far outside the lines, it is probable that they will raise some IRS audit red flags and their margins that will eventually catch up to them.
IRS Audit Red Flags – Part Ten
I love the entrepreneurial spirit that many small business owners have and have dedicated my life to helping them solve their tax, legal, and business problems.
Why they require my help is that many of them, as great as they are at whatever they do, fail to keep their house in order when it comes to their internal affairs.
They do not keep their receipts, do not pay themselves a reasonable salary, fail to maintain accurate records, guess on expense categories, and generally make lots of other mistakes.
I love my clients, have come to accept this about them, working hard to keep their houses in order.
Unfortunately, there is usually a lot of upkeep associated with a small business and many people fail to keep it together. This is no secret among attorneys and tax practitioners, and, unfortunately no secret from the IRS.
Unlike a straight W2 employee, small business tax returns are much more complicated and leave a lot of room for error. This error often translates into tax loss for the IRS and, therefore, makes small business owner tax returns a frequent target of IRS review. Statistically, they are just more likely to get popped.
The moral here comes back to one of my favorite borrowed sayings that “an ounce of prevention is worth a pound of cure.” If you own a small business then it really does pay to keep good and accurate records and translate those records into accurate financial statements and tax returns.
I know there are a million things to worry about with your small business. Emergencies and minor crises pop up every day and some people simply have too much on their plate to worry about record keeping.
However, by keeping up with these things or by outsourcing them to someone else, you will save yourself the day that the IRS comes knocking at your door. If I live in Seattle and it is more likely to rain there, I will probably buy an umbrella. If I move to Northern Minnesota, I will probably invest in a good winter coat.
Similarly, if I am in the profile of people that may have one of the highest margins of error on their tax returns and are statistically more likely to get audited, it would probably be a good idea to take out some audit insurance in the form of good recordkeeping should that day ever come. I am not saying it will, I am saying just in case.
In conclusion, no one can be 100 percent certain of what their audit risk is or can fully audit proof their tax return, but prudence is the best way to safeguard yourself. Be mindful of where the dangers are, keep honest and accurate records (especially for major events), and if the IRS does ever come around, you can rest easy knowing that you have nothing to worry about.
How to Prevent an IRS Audit
Full disclosure here, the IRS does not reveal the exact criteria that it uses to audit a tax return. However, this closely guarded fact is not so much of a secret anymore.
Not surprisingly, the government uses statistics to analyze tax returns and to determine which taxpayers it selects for IRS audits.
Shameless self-promotion alert: I have also written a pretty comprehensive list of the factors that the IRS that are known by tax attorneys as “audit red flags.” However, in this post, I want to discuss perhaps the most important factor in avoiding an IRS audit: making it bulletproof from the scrutiny of the IRS.
Here’s a quick recap about how IRS audits work:
- All tax returns are processed into a computer, where they are assigned two scores: a DIF score (assessing the potential changes on a tax return [i.e. increased revenue]) and a UDIF score (assessing the potential that there is unreported income on a tax return).
- Returns with high scores are sent to an IRS reviewer, who manually examines a return to determine its potential for audit.
- Those that are selected by the reviewer are sent to local field offices where a revenue agent will conduct an IRS audit.
- Those not selected by the reviewer are tossed back into the pile (so to speak) and are safe from audit.
The fact of the matter is the IRS only conducts a certain amount of IRS audits every year. Because of this, it selects the tax returns that are most likely to yield revenue or that contain the greatest potential for error for additional review.
Think of it from the government’s perspective: why would they devote manpower, time, and limited resources toward auditing a return that is likely not going to yield them additional revenue? Answer – they probably won’t.
Would You Like To Know More?
So, how does this all relate to you, your tax return and avoiding an IRS audit? Simple. When preparing your return this year, start with asking yourself this question: DOES MY TAX RETURN MAKE SENSE? Followed by:
- Is all my income accounted for and reported correctly?
- Do the deductions listed on my Schedule A (where you itemize) make sense?
- Do I have excessive charitable contributions for someone of my income level (especially in comparison to the past three years)?
- Do my business expenses make sense (are you a plumber that wrote off international travel)?
- Are said expenses likely to be considered ordinary and necessary by the IRS?
Do you see where I am going with this? Most of the tax returns that come across my desk which have been selected by the IRS for an audit have some burning questions that I cannot answer off the bat.
They are like the video ads in Starship Troopers that keep asking, “Would you like to know more?” (Yes, I was able to make a Starship Troopers reference in a tax article).
If your return comes across my desk and I am left asking questions, then that’s probably the reason your return was selected for an IRS audit – i.e. the manual reviewer had those same questions.
So spend the extra time to make sure that everything on your return makes sense and, if it doesn’t, then attach a supplemental statement to the return that explains certain items. This is allowed by the IRS.
Little used by tax professionals and individuals preparing their returns, these statements can actually help you avoid an audit by giving you a chance to explain items that may be problematic on the return.
More than that though, a well-written articulate statement written about an item on a tax return sends a message to the reviewer that the person on the other end of this return has his or her ducks in a row.
If that person is prepared to defend their return, then there is a good chance that auditing that return will lead to no change. If it leads to no change, the IRS will likely not want to audit it.
So here is the takeaway: if your return makes sense and everything is well explained, then you will likely never encounter the pain of going through an IRS audit.
You will be able to avoid hiring people like myself, digging out old records, devoting significant time and expense.
My advice is to take the extra time going over everything, making sure everything on your return is in order.
Hire a competent CPA or tax attorney like this guy, to prepare your return. Go through the motions now to save yourself a lot of trouble later.