July 25, 2020

Red Flags for IRS Audit | Why Does the IRS Audit You | Legacy Tax & Resolution Services

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Red Flags for IRS Audit | Why Does the IRS Audit You | Legacy Tax & Resolution Services

No one wants to have to deal with an IRS audit, but unfortunately, it is a possibility. The idea is to avoid this very stressful event through prevention. Many people don’t realize that there are several circumstances that can trigger an IRS audit. Understanding these triggers will help you limit your chances of having to endure this stressful event. In this article, we will discuss the potential triggers and how to minimize them.

An IRS Audit can be triggered in several ways. Even taxpayers who believe they’ve correctly completed and submitted their tax return, may find themselves facing an audit.
In addition to incorrectly reporting income, some of the most common audit triggers include taking too many business deductions, operating a cash-only business, failure to report brokerage activities and not reporting money in foreign bank accounts.
When an audit is triggered, hiring a Tax Attorney or Certified Tax Resolution Specialist is the best way to deal with this lengthy and stressful process.

Easy Article Navigation

1 The IRS Computer System

2 Failing to Report Income

3 Money in Foreign Bank Accounts

4 Taking Too Many Business Deductions

5 Earning Beyond a Certain Threshold

6 Dealing in Cash

7 Dipping into Retirement Funds and failing to report the income or penalties

8 Business vs. Hobby

The IRS Computer System

The IRS receives millions of tax returns every year and to review these returns for audit potential, the agency uses something known as the Discriminant Inventory Function System (DIF). This system scans every tax return received, and if it detects something unusual with the return, it will flag for assignment to an IRS agent. The agent will review the items flagged by the DIF Scoring system. If the agent agrees that an audit is warranted, the agent will make a referral for audit. If the agent clears the items, you will never know that you were under review and have passed the first step in the audit process.

To avoid an IRS audit, you need to make sure your return is prepared in such a way to avoid being flagged by the DIF system. When the system scans your return, it searches for a variety of issues. Being aware of these issues can substantially decrease your chances of being audited.

Income Reporting

When completing your return, you must be certain that the income you are reporting matches the income listed on the IRS’ transcript. The IRS receives copies of 1099s, W-2s, 1098s, etc. from third parties. You return is compared to the IRS transcript to insure you have reported all income. If you fail to report all income, you will receive a CP 2000 notice.

Social Security Number Matching

The DIF system also scans the Social Security numbers listed on all returns. If a social security number is listed on two returns, such as in the case of a dependent, the system will flag both returns for review.

Failing to Report Income

The most common reason you may face an audit is the failure to report all of your income. Fortunately, this is also the easiest audit trigger to avoid.

Most people that fail to report all their income, aren’t doing so intentionally. You may have multiple institutions and have multiple sources of income. Some sources of income that are easy to forget to report include:

Form 1099 income from contract work.
Dividends and interest from a brokerage account.
Security sales from a brokerage account, even if you lost money.
College savings account distributions.
Health Savings Account distributions

The IRS will compare the income listed on these forms to what you reported on your tax return. If they don’t match, an audit will be initiated. Avoid audit triggers can be tricky.

THAT’S WHY YOU NEED TO CALL Legacy Tax & Resolution Services – 855-829-5877

Money in Foreign Bank Accounts

Having foreign bank accounts can also result in an IRS audit. Under the Foreign Account Tax Compliance Act, there are very strict rules for reporting money held in foreign accounts. First, the foreign banks must inform the IRS of any account holders who are also United States citizens. Taxpayers who own foreign assets worth $50,000 or more must report these assets on IRS Form 8938. Taxpayers whose aggregate value in a foreign account exceeds $10,000 or more, must report these accounts on FinCEN Form 114 (FBAR).

Previously, reporting foreign assets only required checking a box on your tax return. Now, there are three different steps to report foreign assets:

Check the box.
Identify the bank at which your foreign account is held.
State the highest amount held in the foreign account during the previous year.

These new regulations, designed to promote transparency, mean that taxpayers with foreign bank accounts are also much more at risk for an audit. This is because it can be easy to make a mistake with these reporting requirements. The IRS views possession of a foreign bank account as an attempt to hide money from the IRS.

Taking Too Many Business Deductions

Understandable, the goal of most business owners is to lower their biggest expense- taxes. As a business owner, that likely means taking advantage of every tax deduction possible. While this is understandable, it usually means that you are increasing your chances of being audited.

The IRS tracks different professions and their typical expense amounts. If your expenses exceed the standard for your profession, you have increased your chance for an audit.

IRS pays particular attention to vehicle expenses. Incorrectly deducting a business vehicle is another reason you might have to deal with an audit. Excess business mileage as it related to your listed profession can trigger an audit. Follow the instructions for Form 2106 and properly substantiate your vehicles expenses.

Business meals is another area the IRS watches closely. Deducting business meals can often be tricky, particularly if you are deducting more than the norm for your profession.

Earning Beyond a Certain Threshold

The amount that you earn can also contribute to your likelihood of being audited. Typically, 1 the audit rate for taxpayer with under $200,000 in earnings is usually around 1%. If you earn above this threshold, your chances of being audited have increase. The more you earn, the more likely an audit becomes.

The reason that higher-earning individuals and businesses are more at risk for an audit is that their tax returns are more complicated than those who earn less. The IRS also wants to maximize taxes collected, and auditing higher earners usually results in more taxes collected than auditing people and businesses that earn less money.

Dealing in Cash

In an increasingly digital world, cash transactions have become rare, which is why the IRS views large cash transactions as suspicious. Businesses and institutions must report cash transactions of $10,000 or more to the IRS. If you are flagged, you can expect an audit notice in your mailbox.

Operating a cash-only business is a common audit trigger. The IRS’s assumption is that cash-based businesses can more easily hide income since they may not document most transactions. The biggest red flag is if the income on your tax return does not match your lifestyle.

Dipping into Retirement Funds Without Reporting the Income or Penalties

If you’re facing a financial crisis, it may be tempting to dip into your retirement. The reason that this can result in an audit is that people who dip into their retirement fund typically make mistakes on their tax return related to this money by failing to report the income or penalties.

The mistake that many taxpayers make when dipping into their retirement fund is failing to pay the early withdrawal penalty. If you take retirement money early and are 59.5 years old or younger, you must pay a 10 percent penalty. If you’re older than this and take a withdrawal, you won’t need to pay a penalty, but income taxes will usually apply to the money you withdrew.

There are certain situations where the early withdrawal penalty will not apply:

You become permanently disabled.
You take money out of your IRA to pay for non-reimbursed medical expenses.
You are a first-time homebuyer and have withdrawn $10,000 or less from your retirement to pay for your home.
You have passed away before the age of 59.5. The penalty will not apply to your beneficiaries or estate.

Business vs. Hobbies

IRS audits are much more common for those who work as freelancers or sole proprietors. Independent contractors and sole proprietors have access to a variety of deductions, and as we’ve discussed previously, the more deductions that you take, the more likely you are to be audited.

Business deductions must be reported on Schedule C and can even exceed income. The IRS may audit your tax return if they believe that you are trying to claim that your hobby is actually a business. The IRS has a variety of rules that it uses to distinguish hobbies from businesses and failing to understand these rules can result in an audit. For your hobby to reach the level of a business, you must have a profit motive. The IRS looks for you to have earned a net profit in three tax years out of the last five, in its decision of whether to audit. The biggest distinction between a hobby and a for profit business, the hobby can only take expenses UP TO the amount of income.

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