In 2017, the IRS processed more thanand other forms. They collected more than $3.4 trillion and issued more than 121 million returns, which came in at $347 billion. Only 0.6 percent of accounts got audited.
This represented the lowest audit figure since 2002. That said, 18,692 audits of corporation tax returns also occurred. To be clear, tax audit red flags can get you in loads of trouble with the IRS.
Fortunately, you’re reading this article, which means you’ll soon gain the knowledge you need to avoid what triggers an audit. Let’s dive into the nitty-gritty.
Not Reporting All Taxable Income
One of the surest ways to end up audited by the IRS remains not reporting all of your earned income. Remember, the IRS gets copies of all of your W-2s and 1099s, so don’t think you can pull the wool over their eyes.
What’s more, with today’s technological advances, it’s never proven easier for IRS agents to match the numbers on tax forms with what you report. Computers do all of the work. Within minutes, your account can get red-flagged.
But what if you receive a 1099 that doesn’t contain the correct information about the income you earned? Then, get proactive. Contact the issuer and ask them to issue a corrected form that they file with the IRS.
Forgetting About That Foreign Bank Account
The IRS loves a good mystery, like figuring out which foreign countries you’ve stashed your money in. And when they find these forgotten bank accounts, you’re in for some serious scrutiny.
Nothing increases your IRS audit risk quite like unreported foreign accounts. Especially if said money resides in a country with an established reputation as a tax haven.
What’s more, nobody proves better than the IRS at persuading international banks to give it up when it comes to your bank account information. So, do yourself a huge favorite, and fess up to what you’ve got overseas.
How? Electronically file a FinCEN Report 114 (FBAR) no later than April 15th. (If you miss the deadline, the IRS even provides you with an immediate six-month extension.)
What do you need to report? Any foreign accounts whose combined totals exceeded $10,000 during any period during the last tax year.
What if you have some serious dough to report in other countries? You may also need to fill out and attach.
Earning A Lot of Money
The more money you make, the more interested the IRS will be in you and your finances. Period.
So, if you make between $200,000 and $1,000,000 or more each year, you’ve got a big, red target painted on your back.
That doesn’t mean you should start slacking and give up all of your money-making efforts. But it does mean that you need to remain vigilant when it comes to documented deductions, reported income, and more.
And if you report $1 million plus in earnings? First of all, congrats! Second, your odds of an audit skyrocket.
So, keep your finances in order and make sure you work with an accountant and tax professional so that your tax returns prove bulletproof.
Running Your Own Business
When it comes to audit red flags, being self-employed ups your odds of IRS scrutiny. While Schedule C provides excellent ways for entrepreneurs to seek and receive tax deductions, it also represents your IRS agent’s favorite bedtime reading.
The IRS check Schedule Cs with a fine tooth comb, especially when it comes to high-profit sole proprietorships.
Three especially potent IRS audit triggers remain:
- Business owners who report substantial losses
- Sole proprietorships that gross $100,000 on Schedule C
- Owners of cash-intensive businesses
- People who make a living through freelance service gigs in the sharing economy (e.g., Grubhub, Rover, Uber)
As a small business owner, you need to take this threat seriously. Work with a tax professional to ensure your deductions prove ironclad. April is no time for unwanted surprises.
Reporting Losses for Activities That Look More Like Hobbies Than Businesses
Another one of the IRS red flags to watch out for as a small business owner. If you have a hobby that results in a loss of income that you claim on Schedule C, you’re a prime IRS target.
The risk intensifies if your activity sounds more like a hobby than a profit-generating enterprise. It also goes up if you report lots of income coming in from other sources.
To deduct losses associated with a small business, you have to run it like a business. Your entrepreneurial activities most also evidence a reasonable profit-yielding expectation.
How do you guarantee that you meet these criteria? Your business needs to turn a profit three out of every five years. And if you’re a horse breeder, you better be in the black at least every two out of seven years.
To steer clear of this risk, run your small business like a real business rather than a hobby. What’s more, keep thorough records for all small business-related expenses deducted.
Claiming Disproportionately High Deductions
While we’re on the topic of deductions, here’s what else you need to keep in mind as a small business owner.
If the IRS sees disproportionately large deductions for your business coupled with disproportionately small profits, you’re likely to have your return reviewed.
That doesn’t mean you shouldn’t take those deductions that you can honestly claim. But make sure you have a clear paper trail to support those deductions. And whatever you do, stop taking deductions for entertainment.
That deduction went kaput with last year’s tax reforms.
Making Charitable Donations in Excess of Your Reported Income
But what about charitable deductions? You’ve got to be on top of your game when claiming these. Again, if your charitable deductions greatly exceed your income, that’s audit bait.
Why? The IRS has an established average charitable donation amount for each income level. When you exceed yours, agents step in to find out what’s going on.
You’ll also need to back up the deductions that you do take with clear documentation. That means making sure you get an appraisal for valuable property donations.
For non-cash donations exceeding $500, don’t forget to file a, or you risk further tax scrutiny.
Learn more about charitable giving and how it impacts your small business.
Reporting Rental Losses
What if your small business involves real estate?
Reporting rental losses puts you in a tax class that IRS agents enjoy examining. Although passive loss rules typically prevent homeowners from claiming rental losses, two exceptions to the rule exist:
- You are a real estate professional who devotes more than 50 percent of their time (at least 750 hours per year) to participating in the real estate market as a developer, landlord, broker, etc.
- You are a landlord who actively participates in the business of renting your property.
For real estate professionals who meet the first criteria, they can write off their rental losses.
For landlords who meet the second criteria, you can take up to $25,000 in allowances. But this phases out once your gross income climbs past $100,000. What’s more, it gets phased out entirely at $150,000.
As tempting as reporting rental losses may be, know that your tax returns will be rigorously reviewed. Especially if you go the real estate pro route.
For real estate pros as well as landlords, expect to have the hours you worked in the past year scrutinized for discrepancies. If you have a day job in an area other than real estate, you’ll prove an even juicier target for IRS analysis.
Owning and Operating a Marijuana Business
Here’s a particularly sticky tax situation for marijuana (MJ) growers and dispensary owners. Yes, MJ is now legal in some states. But it’s still illegal at the federal level.
What does this mean for you and your small business?
You can’t write-off any business-related expenses apart from the cost of the weed. Why? Because federal regulations prohibit tax deductions for controlled substance sellers.
Even though marijuana might not be considered a controlled substance in your state, it remains defined as one by the federal government.
What’s more, of the cases that have already gone to court on this matter, judges have consistently sided with the federal government.
Accept the fact that IRS agents are eyeing your business for improper write-offs, and keep your nose clean.
Receiving an Early IRA or 401(k) Payout
Here’s another one that the IRS loves to sink its teeth into — early 401(k) and IRA distributions. Agents want to verify whether or not you correctly reported and paid the tax on this initial payout.
What’s more, if you receive the distribution before the age of 59.5 years old, you set off some major tax audit red flags. Why? Because these early payouts prove subject to a 10 percent penalty above and beyond the established income tax.
The IRS maintains a chart that records withdrawals made before the age of 59.5 that were exempt from the 10 percent penalty due to permanent disability, significant medical expenses, etc.
Using a Schedule C to Claim Day-Trading Losses
If you trade in securities, then you understand the significant tax advantages that you enjoy over investors. Expenses associated with trading prove fully deductible and get claimed on a Schedule C.
What’s more, traders’ profits remain exempt from the tax that other self-employed individuals must pay. Nice set-up, right?
But here’s the rub. You have to meet particular criteria to qualify as a trader to take these deductions. What do these criteria look like?
To qualify as a trader, you must:
- Remain continuously involved in trading activities
- Attempt to make money on short-term price swings
- Buy and sell securities often
This definition clearly distinguishes traders from investors who look to long-term appreciation and dividends to make profits. Unlike traders, investors also trade less frequently and hold their securities for extended periods.
That said, investors don’t get the same tax breaks as traders. Not by a long shot. So, it can prove mighty tempting to pass yourself off as a trader rather than an investor, and the IRS gets this.
They regularly pull returns and pour over them looking for incongruent information that proves a trader’s an investor. This is a dangerous trap that leads to a nasty audit, so don’t find yourself in this situation.
Gambling with the IRS
Do you bring in revenue by betting at the racetrack or playing poker? If so, then you need to count these earnings as taxable income.
If you’re a professional gambler, you’ll do this reporting on Schedule C. If you classify as a recreational gambler, on the other hand, you’ll do this on the 1040 form.
Failing to report these earnings, will draw IRS ire, especially since casinos report their losses (your gains) on Form W-2G.
If you take it a step further and claim massive gambling losses on Schedule A, expect your tax return to be an IRS favorite.
What’s the first thing they’ll check? Whether or not you’ve also reported your gambling winnings. After all, nobody’s luck proves that bad. The last thing you want to do is test your luck with the IRS.
Messing Up on your Health Premium Tax Credit Reporting
When it comes to the Health Premium Tax Credit, make sure your reporting proves accurate and on the up-and-up. IRS agents are jonesing to catch people who receive the subsidies and either fail to file tax returns or file erroneous reports.
When you sign up for the Health Premium Tax Credit through the Health Marketplace, you decide whether you want the credit paid in advance to lower your monthly insurance payments.
If you say yes to this option, then you’ll need to file and attach Form 8962 to your return. This form allows you to calculate your actual credit against the subsidy paid to the insurer. Then, you reconcile both together.
Your Ultimate Guide to Tax Audit Red Flags
Interested in learning more about how to minimize your tax audit red flags? Or, maybe you’ve got questions about small business loans, co-working spaces, or other entrepreneurial issues? We’ve got you covered.
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