Red Flags That May Trigger an Audit
February 27, 2018 by Amy Johnson, CPA
An IRS audit is an examination of an individuals (or business) account to check that information and amounts recorded are reported correctly. Being selected for an audit does not necessarily mean there is a problem. Returns can be selected based solely on a statistical formula. They can also be selected if they involved transactions with other taxpayers who are under audit.
The IRS won’t publish a list, but there are several items that are known to raise the IRS’s interest in a return.
In fiscal year 2016, individual returns of $200,000 and more had a 1.7 percent chance of being audited and if your income was $1 million or more, you had a 5.8 percent chance. These rates were both large declines from the 2015 fiscal year. If these numbers scare you just think about it this way: in 2016, only 0.7 percent of all individuals were audited, the lowest number since 2003.
It’s not just your income, it’s the numbers on your return that are likely to flag it. Here’s a list of items tax preparers believe trigger an audit. Some items only apply to individuals or individuals who file a Schedule C, while others apply to both individuals and businesses. In some cases, items are likely to only generate a letter from the IRS requesting documentation for the item.
High property contributions.
Substantial charitable contributions of property require an appraisal and certain return attachments.
High mortgage interest.
The maximum amount of qualified home indebtedness was $1.1 million in 2017 (including home equity loan), but $750,000 is the maximum for 2018. A mortgage interest deduction that’s more than a certain percentage of the debt limit could indicate an excessive deduction.
Failure to report gambling winnings, interest and dividends, non-employee compensation (1099-MISC), K-1 items, etc. may just trigger a letter and bill from the IRS — or it could generate an audit.
Miscellaneous itemized deductions.
Breaking the 2 percent of adjusted gross income threshold is difficult, so large miscellaneous itemized deductions may perk the interest of the IRS.
Banks and merchants are required to report cash transactions in excess of $10,000. If you have a business, the IRS may want to know where you received the cash from.
Rental losses of a real estate professional.
A qualifying individual can deduct rental losses more than the usual $25,000 limit. Meeting the required time involved in real estate activities and substantiating it isn’t easy. Checking the box on Schedule E could increase your audit chances.
This can be a complicated area where appraisals and other outside information may be required.
Bad debt losses.
Again, this is often a complex area. Many taxpayers lose on this issue because they can’t show a valid debt existed or that a loss occurred in an earlier or later year.
If you use a portion of your home exclusively for your business, you can deduct the expenses and depreciation associated with the space. But you’ve got to show the business connection and that the space was used exclusively for business. Both can be challenged by the IRS. The tax agency can also question the expenses involved in a home office. There’s plenty of opportunity for an IRS auditor to adjust. In general, the higher the percentage of the home claimed for business, the greater your audit chances.
Claiming to be a day trader and taking losses on Schedule C is a red flag.
Net operating loss.
If your business (sole proprietorship, S corporation, partnership) has losses you may have an NOL (net operating loss) that can be carried back or forward to offset income in other years. You may be asked to substantiate the loss if you claim a refund for an earlier year or on a later return where the NOL is used.
These could be challenged if there’s no revenue from the property.
Multi-year losses on Schedule C (or a pass-through entity such as an S corporation) may be scrutinized, particularly if the business is listed as one that has elements of personal pleasure such as horse breeding, photography or auto racing. Your audit chances increase if the losses offset substantial other income on the return.
If you file a business return such as a Schedule C, S corporation or LLC, there are other triggers. Some of them also apply to rental properties.
Zero officer salaries for an S corporation.
If an S corporation is active, showing no salary for officers is a red flag.
In terms of an IRS audit, larger businesses may have to undergo detailed examinations involving many issues, but for individual taxpayers and Schedule C filers, audits may be limited to selected items — unless those items indicate problems.
What should you do? The law requires you to keep all records used in preparing your tax return for at least three years after the filing date. With the new tax reform the laws can be tricky, the standard deduction has increased, changes were made that will affect virtually every American, so talking to your trusted tax advisor should help with any confusion. Learning the new tax laws, along with help from your CPA will guide you to a stress-free tax return for upcoming years.