There are few experiences that conjure such dread and stress as when a taxpayer has received notification from the Internal Revenue Service that he or she will undergo an audit of their tax returns.
Frankly, it feels like a punch in the gut when you first read those words.
In truth for most people, as CNBC notes, the chances of an audit are slim: of the nearly 148 million individual tax returns filed in 2016, just 0.7 percent (about 1 million) were audited, according to the IRS.
So that begs the question: what’s the item that increases your chances the most?
Making a lot of money. Period.
As the report goes on to say, if you earn more than $1 million, the audit rate jumps to 5.8 percent.
"This is one case where the less money you make, the better off you are," said Bill Smith, managing director at CBIZ MHM's National Tax Office in Washington. While getting contacted by the IRS regarding your return will not always result in owing more to Uncle Sam — sometimes it actually leads to a refund — it usually does mean you face additional taxes, according to IRS data. In 2016 alone, audits resulted in taxpayers forking over a collective $9.8 billion.
Turbo Tax notes that the Internal Revenue Service uses a combination of automated and human processes when selecting which tax returns to audit.
(It’s not a mindless machinery, in other words. There are human hands at the wheel.)
All tax returns are compared with statistical norms, and those with anomalies undergo three layers of review by personnel. Audits then occur either by mail or in meetings at taxpayers’ places of business. They can be unpleasant and are sometimes unavoidable. Certain red flags are sure to draw scrutiny and some are easy to sidestep—unreported income, for example. Others, such as high income, can’t be helped.
Another analysis confirms that less than 1 percent of tax returns get audited by the IRS, but this percentage varies significantly depending on several factors.
In fact, as noted in the link above, there are several red flags that make it far more likely you'll be audited; and there are a few that make it a near certainty.
Here's a list of 10 of the biggest IRS red flags and what you can do to prepare, as explained by The Motley Fool:
1. High income
Not surprisingly, the IRS dedicates more of its limited resources to ensuring that the highest-earning households pay all of their taxes. After all, if it catches a substantial error on the return of a taxpayer who earned $5 million last year, it's likely to bring in significantly more money than a mistake on the return of a $50,000 earner.
2. No income
In addition to looking at high-income returns, where the IRS feels it can get the best potential returns on its efforts, it also likes to examine returns that report little or no income.
3. Unreported income
Here's something that you may not know. When your employer sends you a W-2, or you get a 1099 from a company that paid you for your services, they also send a copy to the IRS. One of the checks the IRS does is to compare the information they've received with the numbers you reported on your tax return. If anything doesn't match up, you can expect to get a bill for the difference.
4. Business deductions that just don't make sense
According to Dave DuVal, chief consumer advocacy officer for TaxAudit, there are several ways that the IRS could potentially flag business expenses.
5. Itemized deductions that are way above average
The IRS knows how much money average people of certain income levels contribute to charity, pay for medical expenses, and so on. Any itemized deductions that are far above the average for someone in your income bracket can be a potential audit trigger.
6. Inflated rental property expenses
"Tax returns with what appear to be inflated rental expenses are frequently caught in the IRS net," says DuVal. "Not knowing the difference between a deductible expense and one that must be capitalized over a number of years could result in a disaster in an audit."
7. Filing status and dependency issues
A quick way to get audited is to claim a dependent who is also being claimed on someone else's return. "When two people claim the same dependent, the IRS gets involved. Although separated and divorced parents who have custody have the clear advantage, they still have to prove everything by providing birth certificates, school records, and more," says DuVal.
8. Not enough income to support your lifestyle
If you claim deductions that don't match your income level, it can be a potential audit trigger. For example, if you claim a deduction for the property taxes you paid on a new Porsche, a $200,000 boat, and a million-dollar home, and your income is $50,000, it could look like you may be hiding something.
9. 100% business use of a vehicle
It's quite rare to use a vehicle you own exclusively for business purposes, and the IRS knows this. Even if you own a car primarily for business purposes, it's likely that you'll occasionally use it to drive your kids to soccer practice, pick up groceries, or run other personal errands.
10. A Schedule C that reports just enough income to maximize the earned income tax credit
Having business income that you report on a Schedule C raises your risk of audit all by itself. Simply put, there's a lot of room for abuse when it comes to business deductions. Your audit risk goes up even more if your Schedule C has just the right amount of income and expenses to qualify you for a big credit, such as the Earned Income Tax Credit.
In conclusion, we highly recommend that you meet with your tax professional to assess your risk of audit and how that risk can be mitigated. The information provided above is not advice but is simply general information.
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