9 IRS Audit Flags You Must Avoid Like the Plague

by Neal Frankle, CFP ®

No matter how passive or aggressive you are when it comes to filing your tax return, please avoid IRS audit flags. You hate paying taxes and you’re certainly not alone. But don’t go too far. Some people take “tax relief” too far!

The IRS reported that $30 billion is lost every year due to tax cheats, according to irs.gov/newsroom. The people involved run the gamut, from stay-at-home folks to high-priced Professional LLCs. No wonder the IRS is looking hard at tax return red flags. (Read “Innocent Spouse Married A Tax Cheat.”)

According to the New York Times, the people who are most able to hide income or inflate expenses are taxpayers who own a business, real estate or investments. That’s where half of the cheating happens.

On the other hand, people who report less than $25,000 of their return also have lots of room to “maneuver.” The other half of tax cheaters are found there.

According to a Pew Research Center poll, 21% of us think it’s OK not to report all income to the IRS. That doesn’t mean one out of five people cheat. It just means that many of us think it’s OK.

What does this mean to you? If you are in either camp, the IRS is looking at you very closely, so beware. Even if you are squeaky clean, if you get audited by the IRS it could waste months of your time and cost you thousands of dollars – to say nothing of the stress.

Here are the top 9 red flags the IRS looks at…

audit flags

1. When You Have High Home Office Expenses

This is a big one. Here’s how it works. Let’s say you have a job you do on the weekend and it turns into a business. You can take a write-off for the expenses related to the use of your home for business use, but be careful. The expenses can include property tax, mortgage expense or rent, utilities, insurance and even depreciation. But to take those deductions, the property must be used exclusively and regularly as the principal place of business. That means you can’t use the space for any other reason at any other time. And this space can’t be for your investment research or hobby either. It must be a bona fide business. This issue is explained in detail in IRS Publication 587.

2. When You Hire Family

There is nothing wrong with hiring family, but be aware that the IRS will look at this closely. It’s often used as a way to take more money out of the business at lower tax rates.

3. When You Have Weird Income

If your income is very low (relative to your lifestyle), you’re walking on thin ice. A friend of mine lives in a very exclusive neighborhood, travels the world and eats out all the time. Yet he reports only $50,000 income every year. He got slammed recently with an audit and a large fine. He was lucky he didn’t go to jail. Don’t let this happen to you.

Also, most people don’t have income that fluctuates wildly, and the IRS knows it. If your income does move around a lot, rest assured the IRS is watching.

4. When You’re a Success

If your income exceeds $100,000, you’re five times more likely to be audited as someone earning less than that. When Willie Sutton was asked why he robbed banks, he replied, “That’s where the money is.” I guess the IRS got the message.

5. When You’re Not a Success

If you have a second job that you run as a side business and you show continual losses, make sure you can prove you are running a business and it’s not just a hobby. Some of the questions the IRS will ask are:

  • Is your intention to make a profit?
  • Do you depend on that income?
  • If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
  • Have you done anything different to increase profits?
  • Do you have expertise in this field?
  • Have you made a profit in similar activities in the past?
  • Is the business profitable sometimes?
  • Is it reasonable to expect a profit in the future?

(from IRS Publication 535)

6. When You’re Too Nice

If your charitable contributions are higher than what other people make in your tax bracket, the IRS will wonder why. And they might come around and ask.

7. When You’re Too Thorough

If you have too many itemized deductions, the IRS will see that as a red flag. That being the case, make sure you can prove any deduction you take. (Read “9 Overlooked Tax Tips.”)

8. When You’re a Slob

If your state and federal returns don’t match, it’s a problem. Also, if your return is sloppy, you have math errors or you fail to complete the return, expect the IRS to knock on your door. If the computer can’t check the return, a human will get involved and take a much closer look. (Just what you need – an extra set of eyes on your return.) This problem will diminish as more people file electronically.

9. When You’re Greedy

If you write off expenses that are really personal expenses, expect trouble. It’s fine to buy business insurance, but not if it’s really covering a car for your personal use. If you have high entertainment and travel expenses, beware. If you buy a watch for yourself and try to call it business equipment, you aren’t fooling anyone.

Just because you have audit flags doesn’t mean you’re going to be audited. And even if you get audited, it doesn’t mean you’ve done anything wrong. This is a question of balance. You certainly want to take all the legitimate expenses you can. But some gray areas may not be worth the tax savings.

What’s your position on audit red flags? Do you take those deductions anyway?

If you like this post, you might also enjoy IRS Refund Schedule.

photo by RVW, Flikr

 

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