Anyone can get audited by the IRS. An audit can be random…it can be related to a transaction you made with someone else who is under audit…or it can result from something you did. The IRS says it has cut the number of auditors by 25% since 2010. But there still are some things that tend to make the IRS want to take a closer look at your tax returns. By recognizing and avoiding these red flags, you might be able to protect yourself from triggering an audit.
Deductions That Slash Taxable Income
Itemized deductions, including charitable donations as described below, can reduce your tax bill, but they also can raise suspicions when they’re disproportionately high relative to income. A taxpayer who came to me after he ran into a problem had earned $21,000 one year and yet attempted to write off $17,000 in itemized deductions, including local taxes, real estate taxes, mortgage interest, charitable deductions and work-related out-of-pocket expenses. This lopsided claim naturally drew scrutiny from the IRS, which wanted to know how the client could afford to survive for a year with so little remaining income.
What to do: Substantiation in itemized deductions is the key to staying in the good graces of the IRS. Make sure you can account for shortfalls that likely won’t make sense to the IRS. Example: The client who wrote off all of his annual income except for $4,000 might satisfy an IRS inquiry by proving that he tapped his savings to survive the lean times.
Excessive Charitable Contributions
The tax code allows taxpayers to write off some charitable contributions, which are among the most common itemized deductions. This reduces your taxable income and ultimately your tax bill. But some taxpayers tend to overvalue what they give, particularly with nonmonetary donations such as clothing. Excessively high valuations can make the IRS take note, which could increase the likelihood of triggering an audit.
The IRS also tends to take note when taxpayers claim charitable deductions that are high relative to their incomes. Examples: One of my clients triggered an audit by claiming $4,000 in charitable deductions on an income of $40,000—an unusually high 10% of income.
What to do: Resist the urge to highball the estimated value of your nonmonetary donations. In IRS publications 526 and 561, available at IRS.gov, the IRS outlines several methods for determining fair market value, which is roughly the amount that you should deduct. There is no set formula, but the estimated value should reasonably match the price that a consumer would be willing to pay for the item in a secondhand shop.
Also, make all donations verifiable whenever possible. Instead of putting money in a charity’s sidewalk bucket, leave a paper trail by writing a check or donating the money online with a credit card. You also need a contemporaneous written acknowledgment for donations of $250 or more. And you need an appraisal if you donate property worth more than $5,000…or art worth more than $20,000.
Appearance of UnderReported Income
The central function of IRS audits is to ensure that taxpayers accurately report what they earn. One of the surest ways to invite a tax audit is to give the IRS a reason to think that you’re concealing income. Example: The IRS questioned one couple who reported a relatively low income that couldn’t have reasonably supported their life in an expensive neighborhood in New York City.
What to do: Never try to conceal income, and be sure to gather and maintain documentation to explain any discrepancies between your income and your lifestyle. Example: The couple in New York had just gotten married, and they were able to provide proof that they had received large cash gifts and parental assistance that temporarily enabled their lifestyle.
Suspicious Entertainment Write-Offs
The IRS generally allows taxpayers to write off up to 50% of qualified business-related entertainment expenses. The key word, however, is qualified. Questionable entertainment write-offs are among the biggest red flags for auditors. It may be acceptable for a business owner to write off part of a dinner with a potential client if the purpose of the dinner was to secure the client’s business. Two friends who are talking about starting a business over dinner, however, doesn’t count.
What to do: Familiarize yourself with the IRS entertainment expense guidelines, which is topic 512 on the IRS website (IRS.gov). Also, keep all associated receipts, bills and other documentation. Business entertainment write-offs require a higher level of substantiation than many other business deductions and often attract more intense scrutiny.
Claims of 100% Business Vehicle Use
If you use a vehicle for business purposes, you can deduct some related expenses. But if you also use the car for personal use, you must distinguish the two and deduct only expenses related to business use of the vehicle. The IRS is likely to become suspicious anytime taxpayers claim 100% vehicle deductions for cars they personally own.
What to do: Always be accurate and honest when claiming mileage or other expenses, and claim a 100% deduction only on a dedicated work vehicle. For example, you can’t claim 100% business use of a work truck if you occasionally drive it to ball games. Maintain a mileage log or use an app for this purpose, and keep all supporting documentation, including gas and toll receipts.
Deductions for Cable- and Satellite-TV
In some situations, the IRS allows taxpayers to write off some portion of cable- or satellite-TV subscriptions. These deductions, however, are known to make the IRS suspicious. You should pursue these deductions only if you bought the subscription purely for work, as in the case of a restaurant owner who keeps a television on for his customers at the business location. People get in trouble when they try to write off some arbitrary percentage of their home cable bills because it indirectly pertains to their work, such as actors watching movies or journalists watching the news.
What to do: A good rule of thumb is that if it’s a cable-TV subscription that you would have had anyway, then no portion is deductible, since business usage does not cost any more. In most cases, this includes your cable at home—unless you can successfully prove to the IRS that you had to obtain a different level of service for business usage and then only that portion would be deductible.
The Real Estate Red Flag
Real estate investors are not real estate professionals. The IRS allows tax-saving exemptions called passive activity losses—but this allowance is reserved solely for industry professionals who spend a certain percentage of time actively participating in the development or management of the property. This does not apply to investors attempting to write off losses associated with properties in which they own stakes.
What to do: Learn the guidelines for passive activity losses (Internal Revenue Code Section 469 or Publication 925) before claiming real estate deductions aside from those associated with your primary residence. If you seek tax deductions as a real estate professional, the IRS is likely to ask how much time and money you spend dealing with the property.
The “Sharing Economy” Red Flag
From Uber drivers to Airbnb hosts, there is a lot of confusion surrounding how “sharing economy” money is reported to the IRS. There’s so much confusion, in fact, that the IRS dedicated a web page specifically to the topic. Search IRS.gov for the “Sharing Economy Tax Center.”
There is no confusion, however, around the fact that the IRS is paying closer attention to independent contractors as the sharing economy goes mainstream. Even though you don’t get a Form W-2 and may not receive a Form 1099-Misc, income from gigs is considered independent contractor earnings, which must be reported.
What to do: Avoid the common mistake of assuming that you don’t have to report income earned as an independent contractor because you “didn’t earn that much.” A single dollar may be reportable.