The Internal Revenue Service (IRS) uses a combination of automated and human processes when selecting which tax returns to audit. All tax returns are compared with statistical norms, and those with anomalies undergo three layers of review by personnel. Here are some items you can do well to be aware of, and have a double review done before submitting the return.
Unreported Income – Unreported income is perhaps the easiest-to-avoid red flag and, by the same token, the easiest to overlook. Any institution that distributes an individual’s income will report it to the IRS, and the more income sources you have, the greater the difficulty in keeping track. The IRS will typically receive a copy of all the tax forms that you do, including distributed income. The IRS will match the reported items to a person’s return. If they see something missing, they will automatically conduct at least a letter audit.
The Foreign Account Tax Compliance Act has strict reporting requirements for foreign bank accounts. The law requires overseas banks to identify American asset holders and provide information to the IRS. Individuals must report foreign assets worth at least $50,000 on the new Form 8938. The regulations demand openness, which in turn increases the likelihood of an audit. That’s because of the perception that taxpayers with foreign accounts are trying to hide income offshore.
Unclear business expenses – The IRS will give a close look at excessive business tax deductions. The agency uses occupational codes to measure typical amounts of travel by profession, and a tax return showing 20% or more above the norm might get a second look. Also, take-home vehicles are not considered strictly business, so a specific purpose should accompany any vehicle-related deduction.
High / No Income – Higher incomes are likely to result in more complex tax returns that are more likely to contain audit triggers. More importantly, the IRS wants to maximize return on investment, something the agency gets better at every year. In addition to looking at high-income returns, where the IRS feels it can get the best potential returns on its efforts, it also likes to examine returns that report little or no income.
Itemized deductions that are way above average – The IRS knows how much money average people of certain income levels contribute to charity, pay for medical expenses, and so on. Any itemized deductions that are far above the average for someone in your income bracket can be a potential audit trigger.
Inflated rental property expenses – As a general guideline, something that is a one-time fix is a repair, while something that increases the value of a property or extends its life is a property improvement. For example, a kitchen renovation is a property improvement, and therefore needs to be capitalized. If you spend $20,000 renovating the kitchen of a rental property and try to deduct the entire expense, it is a big red flag.
Filing status and dependency issues – A quick way to get audited is to claim a dependent who is also being claimed on someone else’s return. People who file as heads of household are also likely to face additional scrutiny. Or, if you have an adult child who you claim as a dependent, who then files their own tax return as an independent adult, it will set off bells at the IRS. Be sure to know the difference and prepare your return accordingly.
Be sure you can document every deduction and credit you claim, so that if asked, you can back it up. Many tax audits do not result in any additional taxes — in fact, about 5% of people who are audited end up getting a refund. Often, the IRS just wants to take a closer look at suspicious-looking items to make sure that everything checks out.
