22 IRS Audit Red Flags
There's no sure way to avoid an IRS audit of your tax return, but these red flags could increase your chances of drawing unwanted attention from the IRS.
Thankfully, the odds that your tax return will be singled out for an audit are pretty low. The IRS audited only 0.4% of all individual tax returns in 2019. The vast majority of exams were conducted by mail, which means that most taxpayers never met with an IRS agent in person. Although IRS hasn't yet released the audit rate for 2020, we expect it will be lower because of the coronavirus pandemic. The IRS put on hold most of its enforcement activities for a few months in 2020. And even though the IRS is slowly starting audits up again, it will be a long time before things get back to normal. That's the good news.
But this doesn't mean it's a tax cheat free-for-all. The bad news is that your chances of being audited or otherwise hearing from the IRS increase (sometimes significantly) if there are certain "red flags" in your return. For instance, the IRS is more likely to eyeball your return if you claim certain tax breaks, your deduction or credit amounts are unusually high, you're engaged in certain businesses, or you own foreign assets. Math errors could also draw an extra look from the IRS, but they usually don't lead to a full-blown exam. In the end, though, there's no sure way to predict an IRS audit, but these 22 red flags could certainly increase your chances of unwanted attention from the IRS.
Failing to Report All Taxable Income
The IRS gets copies of all the 1099s and W-2s you receive, so be sure you report all required income on your return. IRS computers are pretty good at matching the numbers on the forms with the income shown on your return. A mismatch sends up a red flag and causes the IRS computers to spit out a bill. If you receive a 1099 showing income that isn't yours or listing incorrect income, get the issuer to file a correct form with the IRS.
Report all income sources on your 1040 return, whether or not you receive a form such as a 1099. For example, if you get paid for walking dogs, tutoring, driving for Uber or Lyft, giving piano lessons, or selling crafts through Etsy, the money you receive is taxable.
Making a Lot of Money
The overall individual audit rate may only be about one in 250 returns, but the odds increase as your income goes up (especially if you have business income). IRS statistics for 2019 show that individuals with incomes between $200,000 and $1 million had up to a 1% audit rate (one out of every 100 returns examined). And 2.4% of individual returns reporting incomes of $1 million or more were audited in 2019.
The IRS has been lambasted for putting too much scrutiny on lower-income individuals who take refundable tax credits and ignoring wealthy taxpayers. Partly in response to this criticism, very wealthy individuals are once again in the IRS's crosshairs.
We're not saying you should try to make less money — everyone wants to be a millionaire. You just need to understand that the more income shown on your return, the more likely it is that the IRS will be knocking on your door.
Taking Higher-than-Average Deductions or Credits
If the deductions or credits on your return are disproportionately large compared with your income, the IRS may want to take a second look at your return. But if you have the proper documentation for your deduction or credit, don't be afraid to claim it. Don't ever feel like you have to pay the IRS more tax than you actually owe.
Taking Large Charitable Deductions
We all know that charitable contributions are a great write-off and help you feel all warm and fuzzy inside. However, if your charitable deductions are disproportionately large compared with your income, it raises a red flag.
That's because the IRS knows what the average charitable donation is for folks at your income level. Also, if you don't get an appraisal for donations of valuable property, or if you fail to file IRS Form 8283 for noncash donations over $500, you become an even bigger audit target. And if you've donated a conservation or façade easement to a charity, chances are good that you'll hear from the IRS because battling abusive syndicated conservation easement deals is a strategic enforcement priority of the agency. Be sure to keep all your supporting documents, including receipts for cash and property contributions made during the year.
Running a Business
Schedule C is a treasure trove of tax deductions for self-employed people. But it's also a gold mine for IRS agents, who know from experience that self-employed people sometimes claim excessive deductions and don't report all their income. The IRS looks at both higher-grossing sole proprietorships and smaller ones. In 2019, the IRS examined between 0.8% and 1.6% of returns filed by individuals who ran a business and attached Schedule C reporting over $25,000 of gross receipts. Sole proprietors reporting at least $100,000 of gross receipts on Schedule C and cash-intensive businesses (taxis, car washes, bars, hair salons, restaurants and the like) have a higher audit risk. Ditto for business owners who report substantial losses on Schedule C, especially if those losses can offset in whole or in part other income reported on the return, such as wages.
Claiming Rental Losses
The passive loss rules usually prevent the deduction of rental real estate losses, but there are two important exceptions. First, if you actively participate in the renting of your property, you can deduct up to $25,000 of loss against your other income. This $25,000 allowance phases out as adjusted gross income exceeds $100,000 and disappears entirely once your AGI reaches $150,000. A second exception applies to real estate professionals who spend more than 50% of their working hours and over 750 hours each year materially participating in real estate as developers, brokers, landlords or the like. They can write off rental losses.
The IRS actively scrutinizes large rental real estate losses, especially those written off by taxpayers claiming to be real estate pros. It's pulling returns of individuals who claim they are real estate professionals and whose W-2 forms or other non-real-estate Schedule C businesses show lots of income. Agents are checking to see whether these filers worked the necessary hours, especially in cases of landlords whose day jobs are not in the real estate business.
The IRS hasn't always been diligent in pursuing individuals who don't file required tax returns. In fact, the agency has been chastised by Treasury inspectors and lawmakers on its years-long lack of enforcement activity in this area. So, it shouldn't come as a surprise that high-income non-filers now top the list of IRS's strategic enforcement priorities. The primary emphasis is on individuals who received income in excess of $100,000 but didn't file a return. Collections officers will contact taxpayers and work with them to help resolve the issue and bring them into compliance. People who refuse to comply can be subject to levies, liens or even criminal charges.
Tax return preparers who don't file their own personal returns are also in the IRS's crosshairs. The IRS says it will use its directory of preparers with preparer tax identification numbers to identity those who are non-filers.
Writing Off a Loss for a Hobby
Sorry to inform you, but you're a prime audit target if you report multiple years of losses on Schedule C, run an activity that sounds like a hobby, and have lots of income from other sources.
To be eligible to deduct a loss, you must be running the activity in a business-like manner and have a reasonable expectation of making a profit. If your activity generates profit three out of every five years (or two out of seven years for horse breeding), the law presumes that you're in business to make a profit, unless the IRS establishes otherwise. Be sure to keep supporting documents for all expenses.
Deducting Business Meals, Travel and Entertainment
Big deductions for meals and travel taken on Schedule C by business owners are always ripe for audit. A large write-off will set off alarm bells, especially if the amount seems too high for the business.
Agents are on the lookout for personal meals or claims that don't satisfy the strict substantiation rules. To qualify for meal deductions, you must keep detailed records that document for each expense the amount, place, people attending, business purpose, and nature of the discussion or meeting. Also, you must keep receipts for expenditures over $75 or for any expense for lodging while traveling away from home. Without proper documentation, your deduction is toast. It's a sure bet that IRS examiners will also check that business owners aren't deducting entertainment expenses such as golf fees or sports tickets for a client outing. The 2017 tax reform law eliminated the deduction for entertainment expenses.
Claiming 100% Business Use of a Vehicle
When you depreciate a car, you have to list on Form 4562 the percentage of its use during the year that was for business. Claiming 100% business use of an automobile is red meat for IRS agents. They know that it's rare for someone to actually use a vehicle 100% of the time for business, especially if no other vehicle is available for personal use.
The IRS also targets heavy SUVs and large trucks used for business, especially those bought late in the year. That's because these vehicles are eligible for more favorable depreciation and expensing write-offs. Be sure you keep detailed mileage logs and precise calendar entries for the purpose of every road trip. Sloppy recordkeeping makes it easy for a revenue agent to disallow your deduction.
As a reminder, if you use the IRS's standard mileage rate, you can't also claim actual expenses for maintenance, insurance and the like. The IRS has seen such shenanigans and is on the lookout for more.
Claiming the American Opportunity Tax Credit
College is expensive, and the tax law gives individuals some tax breaks to help with the cost. One of these is the American Opportunity Tax Credit. The AOTC is worth up to $2,500 per student for each of the first four years of college. It's based on 100% of the first $2,000 spent on qualifying college expenses and 25% of the next $2,000. And 40% of the credit is refundable, meaning you get it even if you don't owe any tax. This tax saver begins to phase out for joint-return filers with modified adjusted gross incomes above $160,000 ($80,000 for single filers). The student must be in school at least half-time. Eligible expenses include tuition, books and required fees, but not room and board.
The IRS is ramping up its efforts in enforcing the AOTC. Among the problem areas it is focusing on: Taking the credit for more than four years for the same student, omitting the school's taxpayer ID number on Form 8863 (the document used to claim the AOTC), taking the credit without receiving Form 1098-T from the school, and claiming multiple tax breaks for the same college expenses.
Incorrectly Reporting the Health Premium Tax Credit
The premium tax credit helps individuals pay for health insurance they buy through the marketplace. It's available for people with household incomes ranging from 100% to 400% of the federal poverty level. (The recently enacted American Rescue Plan Act of 2021 temporarily expands the rules by allowing even more individuals to qualify for the credit in 2021 and 2022.) Individuals who are eligible for Medicare, Medicaid or other federal insurance do not qualify. Ditto for people who are able to get affordable health coverage through their employer.
The credit is estimated when you go on a marketplace website such as healthcare.gov to buy insurance (the estimated premium subsidy for 2021 will be based on your expected 2020 income). You can choose to have the credit paid in advance directly to the health insurance company in order to lower your monthly payments. You then generally have to attach IRS Form 8962 to your tax return to compute your actual credit, list any advance subsidy paid to the insurer and then reconcile the two figures. Note that for 2020 returns only, the American Rescue Plan Act does not require individuals to pay back any excess if their advance payments received exceed their actual credit. Also, this group of filers with excess advance payments need not attach Form 8962 to their 2020 returns.
Claiming the Home Office Deduction
More people then ever worked from home for part or most of 2020 because the COVID-19 pandemic caused their employers' offices to shut down. These people would love to write off the cost of their home offices. Unfortunately, most won't be able to take the deduction. That's because it's not available to employees. Prior to 2018, certain employees could deduct the cost of home office expenses as unreimbursed employee costs included in miscellaneous itemized deductions, subject to the 2%-of-adjusted-gross-income threshold. But the 2017 tax reform law repealed this group of tax breaks.
The deduction is still available to self-employed people or independent contractors who use a room or space in their home exclusively and regularly as their principal place of business. You don't need to own a home. Renters can also get the break. There are two ways to figure the write-off: Allocate actual costs or use the simplified option in which you can deduct $5 per square foot of space used for business, with a maximum deduction of $1,500.
The IRS is drawn to returns that claim home office write-offs because it has historically found success knocking down the deduction. Your audit risk increases if the deduction is taken on a return that reports a Schedule C loss and/or shows income from wages.
Taking an Early Payout from an IRA or 401(k) Account
The IRS wants to be sure that owners of traditional IRAs and participants in 401(k)s and other workplace retirement plans are properly reporting and paying tax on distributions. Special attention is being given to payouts before age 59½, which, unless an exception applies, are subject to a 10% penalty on top of the regular income tax. A 2015 IRS review found that nearly 40% of individuals scrutinized made errors on their income tax returns with respect to retirement payouts, with most of the mistakes coming from taxpayers who didn't qualify for an exception to the 10% additional tax on early distributions. So the IRS is looking at this issue closely.
The IRS has a chart listing withdrawals taken before the age of 59½ that escape the 10% penalty, such as payouts made to cover very large medical costs, total and permanent disability of the account owner, or a series of substantially equal payments that run for five years or until age 59½, whichever is later.
Taking an Alimony Deduction
Alimony paid by cash or check under pre-2019 divorce or separation agreements is deductible by the payer and taxable to the recipient, provided certain requirements are met. For instance, the payments must be made under a divorce or separate maintenance decree or written separation agreement. The document can't say the payment isn't alimony. And the payer's liability for the payments must end when the former spouse dies. You'd be surprised how many divorce decrees run afoul of this rule.
Alimony doesn't include child support or noncash property settlements. The rules on deducting alimony are complicated, and the IRS knows that some filers who claim this write-off don't satisfy the requirements. It also wants to make sure that both the payer and the recipient properly reported alimony on their respective returns. A mismatch in reporting by ex-spouses will almost certainly trigger an audit.
Alimony paid pursuant to post-2018 divorce or separation agreements is not deductible (and ex-spouses aren't taxed on alimony they receive under such agreements). Older divorce pacts can be modified to follow the new tax rules if both parties concur and they modify the agreement in 2019 or later to specifically adopt the tax changes. The IRS will closely police whether taxpayers comply with the changes. Schedule 1 of the 1040 form requires taxpayers who deduct alimony or report alimony income to fill in the date of the divorce or separation agreement.
Failing to Report Gambling Winnings or Claiming Big Gambling Losses
Whether you're playing the slots or betting on the horses, one sure thing you can count on is that Uncle Sam wants his cut. Recreational gamblers must report winnings as other income on the 1040 form. Professional gamblers show their winnings on Schedule C. Failure to report gambling winnings can draw IRS attention, especially if the casino or other venue reported the amounts on Form W-2G.
Claiming large gambling losses can also be risky. You can deduct these only to the extent that you report gambling winnings (and recreational gamblers must also itemize). The IRS is looking at returns of filers who report large losses on Schedule A from recreational gambling but aren't including the winnings in income. Also, taxpayers who report large losses from their gambling-related activity on Schedule C get extra scrutiny from IRS examiners, who want to make sure these folks really are gaming for a living.
Operating a Marijuana Business
Marijuana businesses have an income tax problem. They're prohibited from claiming business write-offs, other than for the cost of the weed, even in states where it is legal to sell, grow and use pot. That's because a federal statute bars tax deductions for sellers of controlled substances that are illegal under federal law, such as marijuana.
The IRS is eyeing legal marijuana firms that take improper write-offs on their returns. Agents come in and disallow deductions on audit, and courts consistently side with the IRS on this issue. The IRS can also use third-party summons to state agencies, etc., to seek information in circumstances where taxpayers have refused to comply with document requests from revenue agents during an audit.
Claiming Day-Trading Losses on Schedule C
People who trade in securities have significant tax advantages compared with investors. The expenses of traders are fully deductible and are reported on Schedule C (expenses of investors are nondeductible), and traders' profits are exempt from self-employment tax. Losses of traders who make a special section 475(f) election are deductible and are treated as ordinary losses that aren't subject to the $3,000 cap on capital losses. And there are other tax benefits.
But to qualify as a trader, you must buy and sell securities frequently and look to make money on short-term swings in prices. And the trading activities must be continuous. This is different from an investor, who profits mainly on long-term appreciation and dividends. Investors hold their securities for longer periods and sell much less often than traders.
The IRS knows that many filers who report trading losses or expenses on Schedule C are actually investors. So it's pulling returns and checking to see that the taxpayer meets all of the rules to qualify as a bona fide trader.
Engaging in Virtual Currency Transactions
The IRS is on the hunt for taxpayers who sell, receive, trade or otherwise deal in bitcoin or other virtual currency and is using pretty much everything in its arsenal. As part of the IRS's efforts to clamp down on unreported income from these transactions, revenue agents are mailing letters to people they believe have virtual currency accounts. The agency went to federal court to get names of customers of Coinbase, a virtual currency exchange. And the IRS has set up teams of agents to work on cryptocurrency-related audits. Additionally, all individual filers must state on page 1 of their 2020 Form 1040 whether they received, sold, sent, acquired or exchanged any financial interest in virtual currency last year.
The tax rules treat bitcoin and other cryptocurrencies as property for tax purposes. The IRS has a set of frequently asked questions that address selling, trading and receiving cryptocurrency, calculating gain or loss, figuring tax basis when the currency is received by an employee or someone else for services, and much more.
Engaging in Cash Transactions
The IRS gets many reports of cash transactions in excess of $10,000 involving banks, casinos, car dealers, pawn shops, jewelry stores and other businesses, plus suspicious-activity reports from banks and disclosures of foreign accounts. So if you make large cash purchases or deposits, be prepared for IRS scrutiny. Also, be aware that banks and other institutions file reports on suspicious activities that appear to avoid the currency transaction rules (such as a person depositing $9,500 in cash one day and an additional $9,500 in cash two days later).
Failing to Report a Foreign Bank Account
The IRS is intensely interested in people with money stashed outside the U.S., especially in countries with the reputation of being tax havens, and U.S. authorities have had lots of success getting foreign banks to disclose account information.
Failure to report a foreign bank account can lead to severe penalties. Make sure that if you have any such accounts, you properly report them. This means electronically filing FinCEN Report 114 (FBAR) by April 15 to report foreign accounts that combined total more than $10,000 at any time during the previous year. (Filers who miss the April 15 deadline get an automatic six-month extension to file the form.) Taxpayers with a lot more financial assets abroad may also have to attach IRS Form 8938 to their timely filed tax returns.
Claiming the Foreign Earned Income Exclusion
U.S. citizens who work overseas can exclude on 2020 returns up to $107,600 of their income earned abroad if they were bona fide residents of another country for the entire year or they were outside of the U.S. for at least 330 complete days in a 12-month span. Additionally, the taxpayer must have a tax home in the foreign country. The tax break doesn't apply to amounts paid by the U.S. or one of its agencies to its employees who work abroad.
IRS agents actively sniff out people who are erroneously taking this break, and the issue keeps coming up in disputes before the Tax Court. Among the areas of IRS focus: Filers with minimal ties to the foreign country they work in and who keep an abode in the U.S. (note that the U.S. abode restriction doesn't apply to individual taxpayers who work in combat zones such as Iraq and Afghanistan), flight attendants and pilots, and employees of U.S. government agencies who mistakenly claim the exclusion when they are working overseas.