There’s been a great deal of publicity over the IRS getting $80 billion in additional funding over the next decade from Congress. As a result, I’ve had several “concerned” client conversations over the last few months asking if this will result in a greater risk to them of an IRS audit.
With that in mind, it seems like a good time to consider the most common triggers and red flags for IRS audits. And bear in mind, this goes for state audits too, since states like California love, love, love their tax revenue!
Now, despite having a master’s with a tax sub-specialty, please remember that I am not a CPA or tax attorney. Use the information here to guide your decisions regarding filing your taxes. Double-check with your tax professional to make sure this applies to you and your unique situation. As intricately complicated as the Federal (and State) tax code is and worsens by the week, it’s increasingly prudent to not DIY (do it yourself) as regards your tax planning. Just saying…
Still, getting significant tax savings while avoiding IRS red flags … ”Imagine That™!”
Types of Audits
OK … let’s start big-picture and then get more granular.
The IRS has four types of audits. They are not all as portrayed in the movies with the unsmiling accountant-types with the pocket protectors (random thought – do they still even make those?) with a sense of humor similar to stale bread.
Correspondence Audit (aka Mail Audit) – You get a letter from the IRS asking for additional documentation. This is the most common type, and it happens when something on your tax returns doesn’t match the documents they have. A missing Form 1099 or Schedule K-1 is frequently the culprit.
Office Audit – The IRS will let you know what documentation you need to bring to their nearest office. (If you watched the 2022 Oscar-winner for best film “Everything, Everywhere, All At Once,” Michelle Yeoh’s character was called in for an office audit of her business, which was the inciting incident for the plot.)
Field Audit – This is the type where someone will come to your place of business or home (after the nice letter notifying you that this is happening) and go through all of your documents to confirm that what you say happened in the tax year in question really happened versus what they are showing. They do this to compare the lifestyle you say you have to what your tax records are claiming.
Taxpayer Compliance Measurement Program (TCMP) Audit – There is not much you can do about this one except cry and ask everyone, “Why meeeee?” The IRS randomly selects roughly 50,000 returns every few years and requires documentation for every single line of the return. This lets them update their secret algorithm (DIF Score) for their computers to detect anomalies within a group of taxpayers and flag them for the other three types of audits.
A quick note on the DIF score. (The what?) The DIF score (Discriminant Index Function ) is the benchmark for the IRS’s secret algorithm to determine outliers in tax claims. For example, if you’re claiming 20% more deductions than “normal” as determined by the DIF score from others in your income bracket, that will raise a red flag. Lucky you!
Audit Triggers for Affluent Families, Business Owners, and Professionals
So, let’s look at what triggers these events that are about as fun as eating hardtack.
If you’re showing earnings of over $100,000 a year, your odds go up. If you’re earning over $400,000 a year, your odds go up again. And again, for $1,000,000, and for $5,000,000…you get the idea. To the IRS’s thinking, your returns are likely more complicated, and there’s more room for error or more temptation to forget something. From their perspective, there are likely extra tax dollars to be scooped up in those returns!
If you didn’t file a tax return and make more than the $12,950 a year that lets you skip filing taxes, that’s a huge red flag for the IRS. (I still shake my head over people that don’t file and haven’t filed for years. It’s not going to be pretty when they are finally caught!)
Significant Income Fluctuation
The economy has been on a wild roller coaster since COVID happened. Between supply chains, stock market panics, huge shifts in spending habits, and everything else, businesses have not been showing expected returns. Some people made oodles more money than expected, and other industries had to find means of life support.
Even so, if there was a large change in your reported income over the last few years, it increases the odds that the IRS will take a closer look at your tax return(s).
Math Errors & Round Numbers
Transposing numbers if you’re doing your paperwork with a pen happens. Check it carefully. Tax software (or a fantastic tax professional) can help prevent this misstep. But before you sign your returns prepared by someone else, looking them over for mistakes like this can save you a headache later.
The other big potential red flag is rounding numbers. Rounding everything to a 5 or 0 may look tidy and organized, but the likelihood of accuracy is low…which oddly enough means the chances of an audit get higher!
Did you know that the IRS receives copies of your Form W-2, Form 1099, and other documents sent to them independently of what you send in? If your income doesn’t match their records, it’s an easy thing for their software to flag and send you one of those nice audit correspondence letters. So double-check! Make sure you’ve included everything!
In previous years, if crypto was on tax forms at all, it was a tiny box. Now there’s a whole section on it. Cryptocurrency (if you notice the second half of the word) counts as currency, and the IRS wants their share. Pay extra attention to the crypto section this year, and while it’s tricky to trace and find crypto wallets, the IRS will still try.
Large Charitable Deductions
Being generous is a good thing, right? Even if the tax code agrees and lets you deduct charitable contributions, the IRS still gets suspicious if you’re making larger charitable donations than typical for your income range. (Yes, they keep track of all of those things.)
Now, many clever approaches let you donate without fuss and provide good documentation that keeps your tax return reporting “on the straight and narrow.” A strategy my beloved wife and I set up years ago is a Donor Advised Fund (which we call the Family Giving Fund). It lets us make a single donation to the “charitable bucket,” from which we then support various philanthropic causes we believe are making a positive difference in the world. They give us an itemized statement that we can submit with our tax return so that the IRS doesn’t feel the need to double-check our numbers.
Disproportionate Deductions, Losses, or Credits
Just like the IRS tracks the amount of money people in your income/wealth range give to charity, the IRS also keeps track of the standard deviations of deductions, losses, and credits. If you’re taking disproportionately more in any of those categories, the odds of your getting audited go up.
Home Office Deductions
Just because you work from home doesn’t mean you get a home office deduction. I’m sure that’s been a field day at the IRS water cooler.
Unfortunately, you cannot take the home office deduction for working from home if you are classified as a W-2 employee. You’ll need to have a business (self-employed, side-hustle, gig economy, etc.) to get the deduction. This is a change in the rules that happened as a result of the Tax Cuts & Jobs Act of 2017.
Also, your home office needs to be a dedicated space for your work…the kitchen table doesn’t count. (Although, I am here to report that there are several dozen pairs of my wife’s shoes that regularly congregate in our downstairs “dedicated” office! Don’t tell the IRS.)
If you do qualify for the home office deduction, there are several ways to calculate how much of a deduction you can claim. The simplest method allows you to deduct $5 for every square foot of qualifying home office space, up to 300 square feet. That gives you an automatic $1,500 deduction! Cool!
Speaking of things used for your business, how about getting deductions for your cars or other vehicles (or fixed-gear bikes if you’re in Portland)? Some of you are doing that now. Good for you! But can we talk about reality here? Even if you have an office in your home, you are not going to get a 100% deduction for work purposes, so keep that in mind. Any personal use is non-deductible to you or your business if they supply the car.
That said, I average 92% business use on my wheels and 86% for my wife’s car. This happens by having an office in our home (along with our regular office) and keeping very specific records for three consecutive months of the year rather than having to log your mileage every single day! (We use January – March and multiply that mileage by four. Track your personal, medical, charitable, business, and investment mileage, and you are golden!)
There are tons of apps now that can help you track the mileage used just for work so you can report it to the IRS as accurately as possible. Or, I keep a clipboard in each vehicle, and it takes just 2-3 minutes a day during January – March mileage tracking season!
Tax Planning Alert! The IRS audit risk does go up modestly when there are vehicle purchases toward the end of the year with a nice chunk of depreciation tacked on. Talk about being a Grinch!
The IRS likes to see businesses make a profit. After all, if you operate like a Silicon Valley startup reporting losses year after year after year (assuming you don’t have angel investors keeping you afloat), the IRS will start wondering how you do stay afloat. For IRS purposes, businesses exist to make a profit, and hobbies don’t. If you run a business and make no profits over a long time, you merely have a fancy hobby…even if you have the fancy pens and notepads with your business logo and cheesy smile on them!
The general rule of thumb is you need to make a profit at least three out of the last five consecutive years (or two out of seven in horse breeding).
There is a nine-question test the IRS uses to help determine if your activity is a business or a hobby.
- Do you keep good business records, have a business checking account, and generally run your activity like a business?
- Do you put time and effort into marketing and other activities to bring in customers?
- Do you depend on the income from this activity for your livelihood?
- Are your business losses beyond your control or typical startup losses?
- Have you changed methods of operation to be more profitable?
- Do you have business expertise and hire competent business advisors?
- Have you been successful in similar businesses in the past?
- Do you make a profit, and how much?
- Can you expect to make a profit on assets used in this activity in the future?
If you aren’t making a profit over many years and particularly if you have other sources of income, it will look to the IRS like your business is really a hobby. If not a business, then no business deductions allowed. Simple as that.
Rental Real Estate Losses
Owning real estate can get into murky rules very quickly, especially if rental property is part of your portfolio and not your full-time occupation. This can be a tricky area. You’ll want to talk to your tax professional about the details of your specific situation.
You will need to have 10% or greater ownership of and make management decisions for your property to be considered “actively involved” and eligible for current deductions. Your modified adjusted gross income (MAGI) also needs to be $100,000 or less. If you pass these tests, you can take deductions of up to $25,000 for losses.
If not, or if your MAGI exceeds $150,000, the deductions don’t disappear, they are just “suspended.” That is, they can be used later when the property is sold or traded.
You can still qualify as an “active participant” if you hire someone else to manage the property. You just need to qualify with the ownership and decision-making requirements above.
Tax Planning Alert! If you’re using a pass-through entity like an LLC to manage your property(ties), you may qualify for the 20% Qualified Business Income (QBI) Deduction.
Alimony Rule Change
Some big changes happened concerning alimony and divorce in 2019. Previously, alimony paid was deductible, and alimony received was taxable as income. In 2019 and later, however, alimony payments are not deductible, but neither is alimony received taxed as income.
Oh, and if the alimony paid and received numbers don’t match on both ex-spouses’ tax returns, that is a red flag too. (And you thought the arguments were bad before the divorce!) Just be careful to make sure the numbers match.
Gambling Wins and Losses
It’s only a five-hour drive from lovely San Diego to Las Vegas (and much shorter to the Indian gaming centers closer by.) Whether you’re winning money from the casinos or losing money, the IRS wants to know about it. Make sure to keep records and report all winnings. You can only deduct losses when your gambling income exceeds your losses, and you’re using Schedule A on your 1040 to itemize your deductions.
Your Odds of an Audit
The odds of avoiding an audit are still in your favor. At present, less than 1% of people filing their taxes get any type of audit in any given year. Even with the increase in budget and the difference in what we collectively owe the IRS versus what gets paid (the $600 billion “tax gap”), the odds are still low.
You can play the “audit roulette” game since the chances of an audit are relatively low, but I think a little extra attention goes a long way. Plus, the greater your income, using a trained tax professional to prepare your tax documents is a very inexpensive “insurance policy.” It is money well-spent to help prevent or reduce the emotional and time suck of an IRS or State tax audit.
One last thing…if you’re expecting the sale of an appreciated asset this year and want to minimize how much of your hard-earned money Uncle Sam gets, we can help you take steps to prepare accordingly. We can make capital gains taxes, for example, “optional” without increasing the risk of triggering an audit.
Making capital gains taxes optional without increasing the risk of an audit … “Imagine That™!”
Imagine That™! is a complimentary monthly newsletter provided by Wealth Legacy Group®, Inc. that addresses various topics of interest for high-net-worth and high-income business owners, professionals, executives and their families. Sign up to receive our monthly newsletter here.
R. J. Kelly, Wealth Legacy Group®, Inc. – March 2023
Header image on Canva, one design use license