There is not much that you can do to reduce your chances ofIRS auditbecause the formula for calculating who gets audited is not common knowledge. Be aware that certain items and too manytax deductionsare known to be what triggers anIRS audit. When this occurs, they are looking to get something back and are very certain they’ll get it.
1.Cryptocurrencya.k.a., Virtual Currency Transactions
The IRS has identified virtual currency fraud as a top priority, and has partnered with both financial and cybercrime investigation units to search for unreported or improperly reported virtual currency-related income. While early virtual currency investors may have utilized the IRS’ incompetence to their benefit, it is highly unlikely that such methods will continue to be successful.
The IRS will ask for your wallet ID and blockchain addresses to gather detailed information about any virtual currency transactions. You may be asking yourself: “If theIRS auditsmy virtual currencytax returns, can they also audit my non-virtual currency income?”
Given the ambiguous nature of regulations surrounding the taxation ofcryptocurrencyand NFTs, it is highly unlikely that improperly filed virtual currencytax returnscorrelate with improperly filedincome taxes.
At this stage in the process, the IRS is simply interested in enforcing virtual currency taxation compliance.
2. Large Refunds/Net Operating Losses (NOLs)
Generally, the IRS has no issue with small refunds because predicting the exact amount of withholdings needed over the course of the year is a difficult task, especially when factoring in deductions. However, large refunds pose an entirely different problem for the IRS and it has nothing to do with them not wanting to write a large check to thetaxpayer.
First, most large refunds are not associated with standard W2taxpayers, but rather are indicative of large losses on ataxpayer’s return or something that has offset a large amount of tax that thetaxpayerwould have had to pay.As a result, these issues are usually much more technical than a standard return and, therefore, the IRS will usually want to take a second look at those parts of the return to make sure you are right.
The good news is that if your calculations are right, your return may come off the manual reviewer’s desk in a short time, barring other problems. The same issue exists when ataxpayershows a net operating loss that is carried over from a prior year.
Even manytax preparersmake mistakes when reporting net operating losses on a client’s return, the IRS may examine this section of it due to the potentially high margin of error.
3. Mistakes andmath errors
Mistakes andmath errorsare indicative of a lack of care when preparing the return. Zeros, especially double or triple zero, indicate that thetax preparerguessed regarding an expense category or are guessing. I have seen IRS revenue agents (auditors) roll their eyes when they see complicated expense categories come out as a nice even number.
They often just know that thetaxpayeris not going to be able to substantiate that category fully. In the same regard, guessing and using the same end number over and over again may also raise ared flagwith the IRS.
Mosttax professionalswould never advise someone to guess on atax return, but if you are truly stumped and need to make your most honest recollection about an expense category then you might want to vary those guesses to avoid scrutiny. Of course, it never hurts todouble-checkyour math.
4. Large changes of income
Probably one of the mainIRS audittriggersis a large change of income. Of course, there are many unexpected events in life that can cause changes in income such as a loss in job, a windfall gain, or just unexpected good or bad luck in life.
As such, unexpected and significant swings in income can usually be explained fairly easily. However, large inconsistencies in income from year to year may indicate an area of concern to the IRS if the change in income is not readily apparent (i.e. losses of a job would be reflected by a W2).
This is because large shifts in income can also be indicative of someone hiding income in a current or pasttax year. By taking a closer look at the income earned in different years (as well as the substantiating documents), the IRS can sometimes finddiscrepanciesin what ataxpayerearned vs. what they reported.
5. Taking ahome office deduction
If I were asked to name three IRSred flagswhere I saw clients get challenged and usually resulted in a change, this category might top my list.
Home office deductionsand the associated expenses for individuals whose company has a primary location somewhere else tends to traptaxpayerswho are not completely familiar with the nuances of the code. Many people misinterpret the rules associated with the deduction while others simply abuse or try and game the system.
The most difficult arguments to make with the IRS are with thosetaxpayerswho receive a W-2 and are someone else’s employee while still claiming a substantialhome office deductionfor the use of their business.
It is really hard to make an argument, absent special circ*mstances, that an employer either does not provide a suitable primary office location for the employee’s position or does not reimburse them for the out-of-pocket-costs associated with setting up a home office.
Furthermore, some occupations statistically do not normally require home offices. It therefore seems obvious that IRSred flagsmay be raised when you are in one of these professions and claim ahome office deductionon yourtax return.
Just be careful when claiming the deduction (or anyitemized deductions) and always keep good records, including photos of the office environment. If you claim the deduction, know that you are likely increasing your chances of an audit and be prepared for a potential uphill battle.
6. Filing aSchedule C
Mostself-employedtaxpayersaresmall businessowners who run sole proprietorships and therefore must report the income derived from it as part of theirindividualtax returns. The IRS will also expect to see aSchedule Cattached, showing thebusiness income, both its profits or losses. Keeping allbusiness expenses,credit cardreceipts and documentation up-to-date is almost mandatory, especially if you don’t use aCPA.
7. Using round numbers
Mistakes are indicative of a lack of care when preparing the return. Zeros, especially double or triple zero, indicate that thetax preparerguessed regarding an expense category or are guessing. I have seen IRS revenue agents (auditors) roll their eyes when they see complicated expense categories come out as a nice even number.
They often just know that thetaxpayeris not going to be able to substantiate that category fully. In the same regard, guessing and using the same end number over and over again may also raise ared flagwith the IRS.
I would never advise someone to guess on atax return, but if you are truly stumped and need to make your most honest recollection about an expense category then you might want to vary those guesses to avoid scrutiny.
8. Reporting a high volume of cash transactions
Cash is a major auditred flagbecause it creates all sorts of problems for the IRS. It is almost impossible to track cash transactions, it can be easily hidden, most often does not have a clear electronic record to track, and is difficult for the IRS to verify.
One of the big fights that the IRS has been waging for years has been against cash businesses. Hospitality workers who do not report their tips, taxi drivers who collect off-meter fares, retail store owners who sell merchandise off-book, etc.
Cash transactions go unreported by a great manytaxpayers, many of whom believe that they do not have to report the cash (wrong) or who figure that the IRS will never know that thetaxpayerreceived cash.
Specifically, the IRS targets returns wheretaxpayersmay deal with large amounts of cash and consider it an auditred flagwhen a return contains a high probability ofunreported income. The IRS does this by looking for these three methods of fraud:
- Skimming – taking cash from a business prior to it being recorded as a sale. For example, a clerk in a store who does not ring up a transaction and pockets the cash.
- Embezzlement – taking cash after a sale has been recorded. For example, a clerk in a store who takes money out of the cash register.
- Fraudulent Transfers – A transfer of funds listed as an expense when it actually should be recorded as income. For example, a payment listed as being to a vendor that is actually taken by an owner or employee.
These examples illustrate methods thattaxpayerswho deal with lots of cash use to cheat the IRS. They should provide you with a rough idea for the types of things the IRS is looking for when they audit a cash return. As a result,taxpayerswho frequently deal in cash will likely receive increased scrutiny by the IRS.
Another auditred flagrelated to cash (and one that the IRS has been targeting) is thetaxpayerwho makes cash transactions in excess of ten thousand dollars. Banks and other financial institutions are required to fill out currency transaction reports (CTRs) when an individual pays, deposits, or otherwise utilizes over ten thousand in cash.
In addition, those who deposit lesser amounts to try and avoid the CTR (which is called structuring and is illegal) or who otherwise participate in a suspect activity risk having a suspicious activity report (SFR) filed against them.
It is not entirely clear how much these items affect a person’s audit risk. However, it is clear that these documents are reported to and kept track of by the IRS.
9. Having cash or assets in another country
Even thoughtaxpayersmay have perfectly legitimate reasons for engaging in cross border transactions, may own property in other countries and use aforeign bank, such activities make the IRS nervous for a variety of reasons.
First and foremost, the IRS summons authority and the ability of the IRS to demand records from third parties (banks, financial institutions) in foreign countries is extremely limited. Particularly in countries with strong bank secrecy laws. The IRS may not find out about the existence of these assets unless they are voluntarily disclosed by thetaxpayer.
Furthermore, cross-border transactions and hiding assets in foreign countries are often used methods to evade taxes. As such, the IRS now requirestaxpayersto disclose if they have foreign assets on theirtax returns.
They can seek prosecution if ataxpayerlies about it and is particularly cautious of US persons that do. Although the IRS will not audit everyone who has assets or transacts business internationally, your risk of an audit may increase if you do.
It should also be noted that the IRS has increased enforcement efforts against businesses with locations right on the US/Mexico border, particularly those that may deal with large amounts of cash. If you do operate asmall businesslike this, there is an excellent chance you will get audited.
10. You have a high income
If your income falls between $1 million and $10 million per year, you are more likely than any other group oftaxpayersto get audited, with theaverage audit rate in 2015 of 2.53%.
However, the number of field audits have dropped for high-income earners and most are now completed through correspondence. Because of their complexity, some high-income audits can take years to complete.
About how manytax returnsare selected by the IRS for audits each year?
Every year, the IRS sends out thousands of notices totaxpayersinforming them that they have been selected for anIRS audit. Even though most honest people who keep good records have nothing to fear, no one likes to be audited.
Audits are scary situations for manytaxpayers. They involve the government prying into personal financial affairs and requesting sometimes very sensitive financial information.They can and do provoke feelings of fear that thetaxpayerhas done something wrong in the eyes of the government.
What percentage oftax returnsare audited? Your chance is actually very low — this year, 2022, the individual’s odds of being audited by the IRS is around 0.4%. However, keep alert for theIRS audittriggers. Are you a high income earner? Do you trade incryptocurrency? Did you file aSchedule C? These factors could increase the likelihood that you will get audited.
