The possibility of an IRS audit worries many taxpayers, but if you are aware of what the targets are, you have a better chance of avoiding an IRS examination.
Of course, there’s no way to guarantee that your tax return won’t be examined since the IRS randomly chooses some returns to audit. So you should always keep meticulous records to prove your deductions.
With that in mind, here are 12 audit red flags:
Unreported Income: A Major IRS Red Flag
Unreported income is one of the most common triggers for an IRS audit. The IRS uses sophisticated tools to cross-reference information reported by employers, banks, and other institutions with individual tax returns. If a discrepancy arises between what is reported to the IRS and what appears on your return, it raises a red flag. This can include income from freelance work, cash-based earnings, or side gigs that might otherwise go unnoticed. It’s crucial to report all sources of income accurately, no matter how minor they may seem. By doing so, you reduce the risk of an audit and avoid potential penalties, interest, or fines for underreporting income. Keeping thorough records and consulting with a tax professional can further help ensure that you remain compliant and avoid IRS scrutiny.
Missing deadlines.
Missing tax deadlines can quickly attract IRS attention and may lead to penalties, interest, and even increased scrutiny. Filing late without an extension shows a lack of compliance, which may prompt the IRS to look closer at your tax history. For businesses, late filings can also affect other areas, like payroll or estimated taxes, creating a ripple effect of missed obligations. Individuals and businesses should make it a priority to meet all IRS deadlines or file for extensions if additional time is needed. Staying organized and working with a tax professional can help ensure timely filing and avoid the negative consequences associated with missed tax deadlines.
Being self-employed.
Being self-employed can raise IRS attention due to the complex nature of income and expenses involved, along with the higher potential for unintentional errors or underreporting. Self-employed individuals often handle multiple income streams, cash payments, and a variety of deductions, from home office expenses to travel and equipment. These deductions, while legitimate, can be red flags if they seem disproportionately high relative to income. Additionally, the IRS closely monitors self-employed individuals to ensure accurate income reporting and proper classification of expenses. To minimize audit risk, self-employed taxpayers should keep meticulous records, track all business expenses, and consider working with a tax professional to ensure compliance. Properly organizing finances and maintaining clear documentation can go a long way in avoiding IRS scrutiny.
Discrepancies Between Reported Income and Filed Documents
Discrepancies between reported income and filed documents are a significant trigger for IRS audits. The IRS cross-checks the income reported on your tax return against documents such as W-2s, 1099s, and bank statements. If the income reported on your return doesn’t match what was reported by employers or financial institutions, it raises an immediate red flag. For example, failing to report all earnings from side jobs, freelance work, or investments can result in penalties or an audit. It’s essential to ensure that all income is accurately reflected, including income from sources that might not provide a standard form like cash payments or informal contracts. Carefully reviewing all documents before filing and reconciling them with your income ensures you stay compliant and avoid attracting IRS scrutiny.
Claiming Business Losses for Hobby-Related Activities
Claiming business losses for hobby-related activities is a common red flag for the IRS. The IRS requires that businesses operate with a genuine profit motive, meaning they are expected to generate income over time. If you’re claiming significant losses from an activity that the IRS considers a hobby—such as photography, horse breeding, or crafting—it may trigger an audit. To distinguish a hobby from a legitimate business, the IRS looks at factors like the frequency and regularity of the activity, your intent to make a profit, and whether the activity has been profitable in recent years. If the business losses appear excessive or unsubstantiated, the IRS may question your deductions and disallow them, resulting in additional taxes owed and potential penalties. It’s important to keep thorough records and ensure that your hobby is truly a business with a profit-making intent to avoid scrutiny.
Not reporting stock trades.
Not reporting stock trades is a major red flag for the IRS, especially as they receive detailed reports from brokerage firms on transactions made through 1099 forms. Failure to report stock trades, including gains or losses, can result in significant penalties if discovered during an audit. Many taxpayers may overlook smaller trades, or fail to report the sale of investments if they’re sold at a loss, but all transactions must be accurately reported, regardless of whether they result in profit or loss. The IRS uses automated systems to cross-reference broker reports with individual tax filings, so discrepancies are easily flagged. To avoid trouble, it’s important to report all stock transactions, including dividends, capital gains, and losses, and maintain comprehensive records of each trade. Working with a tax professional can help ensure that all investments are properly reported and that you’re compliant with tax laws.
Dealing in Cash Transactions
Operating with significant cash transactions often draws IRS attention due to the heightened potential for unreported income. Cash-based businesses, such as restaurants, bars, retail shops, and freelance services, are especially scrutinized as cash transactions are harder to track and verify than credit or electronic payments. IRS auditors are well-trained in spotting discrepancies, often examining bank records, deposits, and lifestyle expenses to detect possible income misreporting.
To avoid issues, businesses dealing in cash should maintain meticulous records, including daily transaction logs, deposit slips, receipts, and reconciliations. Implementing a structured recordkeeping system not only aids in tax reporting but also helps demonstrate compliance during an audit. Additionally, depositing cash regularly rather than holding large sums can reduce suspicion, as sporadic or unaccounted deposits may be flagged as potential red flags. Working with a financial advisor or accountant familiar with cash-intensive industries can further safeguard against IRS scrutiny, ensuring that income is accurately reported and expenses are clearly documented.
Setting up an illegal trust.
Setting up an illegal trust is a serious red flag for the IRS and can result in severe penalties, including criminal charges. The IRS closely monitors the creation of trusts, particularly those that are designed to evade taxes or conceal assets. Illegal trusts often involve hiding income, transferring assets without proper reporting, or using deceptive means to shield wealth from taxation. Common examples include offshore trusts or trusts that are not properly reported or disclosed to the IRS. While trusts can be used for legitimate estate planning and asset protection, improper use, such as failing to report them or attempting to disguise ownership of assets, can trigger intense scrutiny from the IRS. To avoid legal issues, it is critical to work with an experienced attorney or tax professional when establishing a trust, ensuring all legal requirements are met and fully reported to the IRS.
Unusually Large Charitable Donations Claimed
Claiming unusually large charitable donations can trigger an IRS audit, especially if the donations appear disproportionate to a taxpayer’s income or financial situation. The IRS carefully scrutinizes deductions for charitable contributions to ensure they are legitimate and in line with IRS guidelines. If a taxpayer claims large donations without proper documentation or if the donations seem out of character for their reported income, it raises red flags. The IRS requires donors to have receipts or written acknowledgments for any contribution over $250, and for higher-value donations, such as property or vehicles, additional appraisals and documentation are necessary. To avoid audit risks, it’s essential to keep accurate records of all donations, ensure they are made to qualified organizations, and report them accurately on your tax return.
Misclassification of Workers: Independent Contractors vs. Employees
Misclassifying workers as independent contractors instead of employees is a significant IRS audit trigger. The IRS has strict guidelines for determining whether a worker should be classified as an independent contractor or an employee, based on factors like control over the work, the relationship between the parties, and the nature of the work performed. Improperly classifying workers can lead to unpaid employment taxes, penalties, and interest. Businesses may be tempted to classify workers as contractors to avoid payroll taxes and benefits, but if the IRS determines that the worker should have been an employee, it can result in costly back taxes and fines. To avoid this, it’s important to carefully evaluate each worker’s role and relationship with the company and consult a tax professional to ensure correct classification. Proper documentation and compliance with IRS guidelines can help protect businesses from audit risks.
Filing with Missing or Incorrect Information
Filing with missing or incorrect information is one of the most common reasons for triggering an IRS audit. Inaccuracies on tax returns, such as incorrect Social Security numbers, missing income, or errors in deductions, can raise red flags for the IRS. Even minor mistakes, such as omitting a W-2 or entering incorrect figures from 1099 forms, can lead to discrepancies that are flagged by the IRS’s automated systems. Filing an incomplete return may suggest negligence or an attempt to evade taxes, both of which can attract further scrutiny. To avoid this, double-check all information before submitting your return, ensure all income sources are reported accurately, and review your deductions carefully. If you’re uncertain about any aspect of your tax filing, consider seeking assistance from a tax professional to ensure everything is correct and complete.
Being a “tax protestor.”
Being a “tax protestor” is a significant red flag that can attract intense IRS scrutiny. Tax protestors are individuals who refuse to pay taxes based on the belief that the tax system is unconstitutional or that they are exempt from paying taxes for various reasons. These claims are typically unfounded and not supported by the law. The IRS has a zero-tolerance policy towards such positions and aggressively pursues enforcement against individuals who refuse to comply with tax obligations. Tax protestors often face severe penalties, legal action, and even criminal charges for tax evasion. Additionally, adopting a tax protestor stance may result in automatic audits and prolonged IRS investigations. It’s crucial to understand that tax laws are constitutional, and refusing to pay taxes based on these beliefs can lead to significant legal and financial consequences.
While receiving an IRS audit notification can be unsettling, it’s important to remember that most audits involve straightforward requests for additional documentation. With proper recordkeeping, many audits can be resolved without significant stress.
To further mitigate tax-related worries, consider partnering with a dedicated accounting professional.
A Remote Financial Services professional can provide expert guidance, handle complex calculations and ensure your financial records are meticulously organized. This proactive approach can significantly reduce the likelihood of audit-related issues and offer peace of mind year-round.
Remember, tax laws are subject to change, so staying informed is crucial. Consulting with a tax professional regularly can help you navigate the complexities of the tax code and avoid potential pitfalls.
Ultimately, understanding common audit triggers and maintaining thorough records are essential steps in protecting yourself from IRS scrutiny.