My blog below was prepared with the assistance of Peter Weitsen, CPA, partner at WithumSmith+Brown, PC.
Some red flags that trigger IRS audits may not be ones that you can, or want to, avoid—for instance, making a lot of money. The odds of an audit increase as your income goes up. IRS statistics for 2017 show that individuals with incomes between $200,000 and $1,000,000 and no Schedule C had an audit rate about double that for all other taxpayers. But there are ways to deal with many of the red flags—in part by taking a little extra care in preparing tax returns and being aware of the proper filing requirements, which are pretty clear in the instructions for each reporting form. For instance, if there is a Schedule C, which is used to report income or losses from a business that you operated or a profession that you practiced as a sole proprietor, the odds double again that you will face an audit, but there are ways to reduce those odds.
Here are potential red flags and ways you could deal with them…
- Being self-employed. If you are self-employed, you cannot avoid having expenses that are red flags, but disclosing those expenses on your Schedule C and answering all the related questions can reduce the questions the IRS might have. An example of what to do is to show that for items whose allowable amounts are limited, such as certain entertainment costs or business gifts, you are deducting the right amount. Where the form asks questions—such as what is your inventory method, basis of accounting or home usage for business purposes—you must respond.
- Taking deductions for large charitable contributions and not filing Form 8283. There are strict rules for charitable deductions requiring disclosure for noncash amounts over $500 and over $5,000 (which also has appraisal requirements). Overlooking these will cause an inquiry. Further, very large deductible amounts in relation to your gross income, including low interest and dividends and high mortgage interest, will pique an agent’s interest. Many times the relative amounts do not seem logical. Provide an explanation of what may seem like illogical amounts.
- Deductions for rental losses. These always raise an alarm. They are limited in amount for a given year but can be carried forward. Make sure the Schedule E reporting rental income is fully and properly completed. Form 8582 (Passive Activity Loss Limitation) might also be required to be filed, and this also raises the audit potential.
- Alimony deductions. This requires the Social Security number of the recipient, so do not omit this. If you have multiple former spouses receiving alimony, attach a schedule with the required names, Social Security numbers and amounts. Receiving alimony and neglecting to report it will generate a notice and possibly an audit.
- Writing off a hobby loss. This raises the issue of whether the transaction was engaged in for a profit or is just a hobby and therefore should not be deductible. You may not be able to stop an IRS notice about this, but you can prevail with the proper records and proof of your business intent, such as advertisements, sales and recognition within the industry.
- Deducting business meals, travel and entertainment. These deductions are no longer allowed in many instances. Where they are not, make sure you identify the clearly deductible purpose when listing these expenses. Instead of showing one amount on the line provided on the form, write in the item with a brief description in the miscellaneous section where items are listed for which there are no lines on the form.
- Failing to report a foreign bank account. This disclosure is a big deal. Failing to check the yes/no box on the bottom of Schedule B is a cause for an inquiry or an audit. Further, if you have income from the foreign account, make sure you report it on Schedule B even if no Form 1099 was provided to you from the payer. And if required, file the properly prepared disclosure form.
- Claiming 100% business use of a vehicle. Unless the auto sits in a garage or in front of the place of business and is solely used for business purposes, it is not possible to have the auto used 100% for business. Be smart and allocate between the actual business and personal portions.
- Incorrectly reporting the health premium tax credit. These are confusing and not always handled properly. Read the instructions, and carefully report the credit properly.
- Taking an early payout from an IRA or 401(k) account. Early distributions need to be reported and, if applicable, you need to self-report the early distribution penalty. This is done on IRS Form 5329. If you believe the penalty should not be assessed, include an explanation of the reason. Further, if you receive a distribution that is rolled over and is tax-free, make sure you report this property on the right line on page 1 of your Form 1040.
- Claiming day-trading losses improperly on Schedule C. Day trading is a type of “business” that is eligible for special tax treatment if a mark-to-market election [7 is made under IRC §475. This permits reporting capital losses as ordinary losses, disregarding wash sales and deducting as business expenses margin interest and trading costs on Schedule C, while the trading transactions would be reported on Form 4797 as ordinary income or loss. Note that this election converts capital gains into ordinary income. None of this income is considered as earned income, so it is not eligible for retirement account deductions or self-employed medial expense deductions. Without the election, the trades are considered capital transactions, with losses limited and expenses treated as investment costs that are no longer deductible on Schedule A. Not treating the transactions properly will likely generate a notice from the IRS and possibly result in an audit.
- Operating a marijuana business. Federal statute bars tax deductions for sellers of controlled substances that are illegal under federal law, such as marijuana. The only deductions permitted are for the cost of the product. Rent, sales and other operating costs are not permitted to be deducted. Those in this business need to know the full tax treatment when reporting their operations. Again, not doing it properly can result in a notice from the IRS.
- Failing to report gambling winnings or claiming big gambling losses. Winnings over $600 and up to $5,000 may generate a Form 1099G, depending on the nature of the activity. You need to be familiar with the rules, which can be found on the instructions for Form 1099G. Failure to receive the 1099G does not negate the need to report the proper amount of winnings. Also, losses are deductible against the winnings, but not in excess of the winnings, nor are any expenses deductible unless you are in the business of gambling (not covered here). Omitting any income or not reporting the losses properly can result in an audit.
- Engaging in currency transactions. Cash received in a commercial transaction of over $10,000 must be reported on Form 8300. Omitting this can cause an audit and create serious consequences.
- Claiming the foreign earned income exclusion. If you lived and worked abroad, you may qualify for an earned income exclusion. This must be reported on Form 2555 and included with your individual tax return. This is something the IRS usually looks at, so it must be properly claimed and reported.
There are other areas where the IRS sends a notice or a bill indicating an adjustment to your return. These are not audits, and the additional tax can be accepted and the bill paid or questioned by writing promptly with your explanation or by providing the correct or corrected information. These notices head off many audits and are working quite effectively for the IRS. But, if you disagree, promptly responding is important. These notices also correct math errors, question incorrect Social Security numbers and add items to your return that you did not report but for which the IRS has a Form 1099, K-1 or other income reporting document that had been filed with them by the payer.