retirement

Watch Out for Tax Audit Red Flags

How to be prepared in case the IRS questions your tax return.

Now that you've completed your tax return, you may be wondering about your odds of an IRS audit. Most people can breathe easy. The vast majority of individual returns escape the IRS audit machine. In 2017, the individual audit rate was 0.6%. That’s one out of every 167 returns filed. More than 77% of these audits were handled solely by mail, meaning taxpayers never met with an IRS agent in person. But there are red flags that the IRS consistently looks for.

Although the audit rate is low, your chances at the unenviable audit lottery escalate depending on various factors, including the complexity of your return, the types and amounts of deductions or other tax breaks you claim, and whether you happen to still be engaged in a business. Also, higher-income taxpayers generally have a greater audit risk.

Failing to report taxable income from wages, dividends, pensions, IRA distributions, Social Security benefits and other sources will almost certainly draw unwanted attention from the IRS, says Laurie Kazenoff, former senior attorney with IRS Chief Counsel and now a partner at Moritt Hock & Hamroff, in Garden City, New York. The agency gets copies of all the 1099s and W-2s you receive. Its computer cross-checks the forms with income shown on your return, and if there is a mismatch it spits out a notice that the IRS will mail to you. (These letters don’t count as audits for purposes of the IRS’s 0.6% figure.) Be sure to report all income, whether or not you receive a form such as a 1099. For example, if you got paid for tutoring, giving piano lessons, driving for Uber or selling crafts through Etsy, the money you receive is taxable.

Claiming big deductions or other tax breaks is another red flag—think larger than normal charitable deductions or medical expenses. The IRS won’t automatically audit someone for having above-average deductions. But if those write-offs are disproportionately large when compared with income, your audit risk goes up because that’s a key factor in the IRS’s return selection process. Taking a big loss from the sale of rental property or other investments can also spike the IRS’s curiosity.

If you are self-employed or run a side business, Schedule C is a treasure trove of tax deductions, and it’s a gold mine for IRS agents. Business owners who report at least $100,000 of gross receipts or a substantial loss on Schedule C have a higher audit risk. If you file a Schedule C with a large loss from an activity that looks like a hobby (think dog breeding and jewelry making, for example) and you have a lot of other sources of income, you’re a prime audit target.

Tips for Handling an IRS Tax Audit

Let’s say you’re one of the unlucky ones who gets a letter from the IRS questioning items on your return. You will likely communicate with the IRS only by mail, but there are a few ways to make the process a bit easier.

Consider hiring help. Kazenoff says that she always recommends having a lawyer, CPA or other tax professional represent you before the IRS. Find a practitioner who is familiar with the ins and outs of the IRS’s audit procedures, who knows the penalty abatement alternatives, and who can assist you before the IRS’s appeals office if you disagree with the auditor’s findings. “It’s like the electrical wiring in your house—you would have a licensed electrician do it to prevent a fire,” says Kazenoff. That said, the choice of whether to bring in a tax professional depends on several factors, including the number of issues involved, the complexity of the items questioned and the dollar amounts at stake.

Make sure you’re prepared. Gather your records to support the items that the IRS is questioning. Try to reconstruct any missing documentation. If you need extra time, call the IRS as soon as possible to request an additional couple of weeks to respond. Provide copies (not originals) of documents, and make sure the records submitted are organized. Don’t stress if your records aren’t perfect. Have a reasonable explanation for any discrepancies.

One thing that’s rarely reported: In 2017, 8% of field audits and 10% of correspondence audits ended with no changes to the returns. And a lucky few walk away with money. In 2017, the IRS recommended refunds in 3% of its audits of individuals.

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