Top 16 tax audit red flagsJan 28, 2020 09:45AM ● By Karen Telleen-Lawton
It’s nice to catch someone’s attention, unless that someone is the IRS. Each year, about a million tax returns are audited, or about 0.5 percent of Americans. That low rate means you probably weren’t audited, but who are the unlucky ones? Even if you and your accountant are meticulous and squeaky clean, enduring an audit is something you wouldn’t wish on that guy who’s talking too loud on his cell phone at the next table.
With limited enforcement funds, the IRS tends to look more closely at tax returns with certain characteristics. None of these factors will guarantee you an audit, but the fewer of them you have, the less likely you’ll be opening a letter from the IRS.
- Not accurately reporting taxable income. W-2, 1099s and other tax forms you receive are also sent to the IRS. They look for the numbers to match, so make sure they do.
- High deductions, including for donations and medical expenses. If your deductions are much higher than expected from taxpayers with your profile, the IRS agent may probe the details a bit more.
- Not taking your Required Minimum Distribution. Remember that after age 70 ½, you must begin to draw down your tax-deferred retirement account. The penalty is sky-high: you’ll pay a 50 percent tax on the amount that should have been withdrawn.
- Taking an early Required Minimum Distribution for a reason not included in the exceptions. Legitimate exceptions depend on your type of retirement plan (Qualified s.a. 401(k) or IRA, SEP, SIMPLE, etc). In general, legitimate reasons include corrective withdrawals (if you paid too much), death, disability, divorce, education, equal payments, homebuyers, medical, military and rollovers. The extra tax on taking an unwarranted early distribution is 10 percent.
- Reporting big losses, such as gambling losses without winnings or a hobby-like business that always loses money. Generally, if you can’t show a profit in three of the last five years, the business is considered recreational and not subject to deductions.
- Claiming day-trading losses on Schedule C (business income and loss). These belong on Schedule D, for capital gains and losses.
- Foreign bank accounts must be reported to the Feds. Likewise, if you ever hold more than $10,000 in foreign currency, you are required to report it. No money laundering allowed!
- Speaking of currencies, you can be flagged for running a business in all, or almost all, cash. Dealing too much or too little in currencies raises suspicions. Digital currency trading may also make an agent look twice.
- Alimony deductions for a divorce after 2018. Alimony is no longer deductible to the payer or taxable to the receiver. If you own your own business, the types and amounts of business deductions can affect whether you’re subject to an audit:
- Business deductions such as unreimbursed business expenses, a home office, business meals, travel and entertainment all can raise eyebrows.
- If your business associates are audited, your chances of audit increase.
- Claiming losses on a rental can be suspect, as can writing off a loss on a hobby.
- Claiming 100 percent business use of a vehicle is seen as unusual.
- Filing form 5213. You wouldn’t think filing a required form would raise a flag, but this form requests the IRS not to audit you for the first five years of a business, as you try to transition a hobby to a legitimate business. Perhaps they just want to be first in line to congratulate you.
- Erroneous calculations, whether by you or your tax preparer, tip off the IRS that there could be additional problems.
- Hiring a preparer who falsifies your return without your knowledge hurts you and your preparer.
Even at only half a percent, odds are you’ll have to submit to an audit sometime in your life as a taxpayer. The best policy is to keep records for the required length of time, be meticulous and turn in your taxes on time. That way, the first level of questions will be a boring exchange of back-up information that proves you’re not worth the next level of inquiry.