Avoiding an IRS Tax Audit

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Just 0.45 percent of taxpayers were audited in fiscal year 2019. Still, with taxes becoming more complicated every year, there is an even greater possibility of confusion turning into a tax mistake and an IRS audit. Avoiding “red flags” like the ones listed below could help.

Red Flags That Trigger IRS Audits

  • Claiming Business Losses Year After Year – When you operate a business and file Schedule C, the IRS assumes you operate that business to make a profit. Claiming too many losses, year after year raises a red flag with the IRS.
  • Failing to Report Form 1099 Income – If you are self-employed or have a second job, resist the temptation to underreport your income. The IRS receives the same 1099 forms that you do, and even if you didn’t receive a Form 1099 when you think you should have, you can’t be sure the IRS didn’t either. If the IRS finds a mismatch, you are sure to hear about it.
  • Early Withdrawals From a Retirement Account – Generally, when you withdraw money from a retirement account before age 59 1/2 you will need to pay a 10 percent penalty. You will also owe income tax on the amount withdrawn unless you qualify for an exception. Sometimes – but not always – these types of early withdrawals trigger an audit.
  • Hobby Losses – Income derived from a hobby such as operating a vineyard or breeding horses must be reported on your return. Expenses are deductible up to the amount of that income. Losses, on the other hand, can only be deducted if the hobby is run in a business-like manner with a reasonable expectation of making a profit. Hobbies that turn a profit in three years out of five (two out of seven for horse breeders) are considered a business.
  • Excessive Business Expense Deductions – Excessive business expenses such as too many deductions for your income and type of business, claiming 100 percent use of a car for business, and inflating business meals, travel, and entertainment expenses are examples of items that could raise a red flag. Always save receipts and document your mileage and expenses.
  • Overestimating Charitable Deductions – Taxpayers can take a deduction for charitable contributions on their 2020 tax returns even if they don’t itemize This an above-the-line deduction reduces taxable income – up to $300 for qualified charitable cash donations – that reduces taxable income. The maximum amount for 2020 tax returns is $300 even if you are married filing jointly. It increases to $600 for 2021 returns.  For taxpayers that itemize, taking disproportionately large deductions as compared to your income could raise a red flag. The IRS keeps records of average charitable donation at various income levels, and even if you inherited a large sum of money and want to donate it to charity, there’s a chance you could get audited.
  • Failing to Report Winnings or Claiming Big Losses – Gambling winnings are reported on Form W-2G, which is sent to the IRS. You must report this income. On the flip side is reporting significant gambling losses, which can only be deducted to the extent of your reported gambling winnings. Professional gamblers report winnings/losses on Schedule C and can deduct costs related to their profession such as lodging and meals for example. Ordinary taxpayers (recreational gamblers) report income/losses on their 1040 tax return and must itemize.

What To Do if You Are Audited

If you’ve received a letter from the IRS indicating that you have been audited, don’t try to handle it yourself. Instead, contact the office immediately for assistance.

Taxpayers who have been audited or otherwise interacted with the IRS should know that they have the right to know when the IRS has finished the audit. Known as the right to finality, it is one of ten basic taxpayer rights – known collectively as the Taxpayer Bill of Rights. All taxpayers dealing with the IRS are entitled to these rights.

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. If desired, we would be pleased to perform the requisite research and provide you with a detailed written analysis. Such an engagement may be the subject of a separate engagement letter that would define the scope and limits of the desired consultation services.