WARNING SIGNALS THAT CAN SET OFF IRS AUDITS

What is an IRS Audits?

An IRS audit is an effective scrutiny or assessment of a taxpayer or business accounts and financial information to make certain the provided information is accurate and complies with tax laws. The IRS conducts audits to ensure the amount you reported on your individual or business tax return is accurate.

Most income tax returns are not audited. This doesn’t suggest you should falsify your tax return, hoping to get away with it. The IRS still considers tax fraud to be a serious offense, so if they notice any falsified claim on your return, they may pay you a visit.

What sets off IRS Audits

There are numerous factors which can set off IRS audit warning signals that can land you in trouble. For example, lying on a tax return to get more money will increase your chances of getting audited. Common warning signals that lead to IRS audit include:

Excessive tax deductions

Various tax reductions can reduce your tax liability for the year. Although, this doesn’t mean you should try and lay claim to every tax deduction. Claiming a deduction that you’re not qualified for can enhance your chances of getting audited.

IRS audits are often initiated when deductions are itemized. Itemized reduction audit risk is usually higher because the IRS will compare your tax return to those with similar incomes. If you have expenses that are drastically different than others similar to you, it might be a focus for attention.

This does not mean you shouldn’t apply for every deduction you’re qualified for. Having all the documents that support each itemized deduction, such as receipts, statements, and getting items appraised if you donate them to charity can aid in preventing an IRS audit.

Self-employed workers

Self-employed workers like freelancers and sole proprietors are qualified for more tax deductions than most taxpayers. This is because they don’t have a portion of their taxes paid for by any employer because they’re their own boss. Therefore, self-employed workers can qualify for deductions for travel and meals, and other expenses to keep their business running. All of these operating costs are listed on Schedule C of their tax return, which goes through the Discriminant Information function System to compare your return to the norm of tax returns for other experts.

Self-employed workers attract additional scrutiny from the IRS because they’re eligible for a variety of deductions. If you’re a self-employed worker, make sure to effectively check your tax return to ensure every deduction you report can be backed up by a paper trail of proof.

Typos and math errors

A simple error, such as a typo or math error, can initiate an IRS audit. For example, submitting the wrong Social Security number or writing down an incorrect number for your income can cause the IRS to look into your tax return with more caution.

The IRS makes use of a computer scoring model called the Discriminant Information Function system, which evaluates your tax return and compares it to the returns of other taxpayers in your tax bracket. The Discriminant Information Function system also checks for unreported income, duplicate information, such as two or more people claiming a dependent, and credits and deductions that a taxpayer might not be qualified for.

Unreported income

An IRS audit can be initiated when you fail to report all of your income. This is because your employer sends a copy of your W-2 Form to the IRS. If you’re a freelancer and get paid more than $600 for services, the body that hired you will send a copy of Form 1099-MISC to the IRS.

Furthermore, if you invest in stocks or other securities, the IRS also gets a copy of Form 1099-INT or Form 1099-DIV. All of these forms are processed through the Discriminant Information Function system, so an IRS red flag can be raised if any wages are unreported.

Deciding not to report any income, including cash from tips and other services, can come to haunt you down the line because the IRS likely has a copy of what you earned throughout the year. To avoid an IRS audit, ensure you contact your employer or the issuer of your 1099 forms to confirm you have all of the required forms to file your tax return accurately.

Deducting 100 percent of a business vehicle

Another factor that could set off an IRS audit is deducting 100 percent of a business vehicle. This is because the IRS knows that it’s highly unlikely a vehicle is used exclusively for business purposes. For example, mileage and gas are deductible expenses for your business vehicle. But, using the vehicle for your commute and deducting the miles isn’t qualified for deduction. If you have another personal vehicle registered under your name, you might be able to deduct 100 percent of your business vehicle. However, you have to have supporting documentation and evidence.

Cash-based businesses

Many cashed-based businesses, like bars, and barbershops and salons, are more prone to being audited by the IRS. This is because it’s simple for business owners and employees to deposit or spend their cash and forget about it come tax time. For the IRS, verifying income earned through cash is tricky, and is called the Tax Gap, which is unreported money spent in the U.S. economy. If you work for a cash-based business, having a lifestyle that doesn’t match your income can raise an IRS red flag. If you’re a Schedule C filer and overstate your expenses or under-report your income, the IRS may become doubtful of your activities. Whenever you report a loss, especially multiple years in a row, the IRS may suspect you’re not disclosing all of your financial information.

Home-based businesses

Conducting business from a home office can also raise an IRS audit warning signal. This does not imply you can’t work from home, but that you need to take extra cautions when you claim home office deductions. When claiming home office deductions, you need to make sure that your home office is used strictly for only business purposes. If the IRS suspects that you’re claiming personal expenses as business expenses or the business use of your home isn’t completely used for business purposes, they may audit you.

Claiming a hobby as a business

The main aim of a business is to generate a profit. If you’re constantly reporting losses for your business, the IRS may audit you to verify if it’s actually a business or a hobby. The IRS will deem your business a hobby if you don’t show a net profit from at least three of the past five years. Additionally, if the income you generate from your hobby isn’t used to help make ends meet, or if you don’t dedicate the majority of your time and money to your work, the IRS will see it as a hobby and not a business.

Reporting a hobby as a business means it must be run like a business. Having the required documentation and reports, along with the intention of making a profit, proves your hobby is actually a business. If your hobby doesn’t qualify as a business, you may be able to take advantage of the IRS’s rules on hobbies so if your business is a hobby for you, you will be IRS Audits.