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Most of us are aware that certain income tax issues are more likely to give rise to an IRS audit than others, so what are they? It is not common knowledge that the IRS can audit you for any reason, but there are commonalities that we typically see.
It becomes much more probable with high income earners that also have a Schedule C which is a supplemental schedule to your form 1040. Schedule C reports income and expenses from a sole proprietorship and single member Limited Liability Companies. Special scrutiny is also given to cash-intensive businesses and people with freelance service gigs through the sharing community (think of Uber, Rover, Grubhub). If the numbers are outside of what is considered normal, the computers will pick it up.
Everything on returns is compared to averages, any outliers will be targeted. Large losses on both individual and business returns will be flagged. If you’re a going concern and have enormous losses they want to know how you’re supporting yourself or how you plan to stay in business.
Speaking of averages, the IRS knows what the average charitable donation is for folks at your income level. So, if your charitable deductions are disproportionately large compared with your income, it raises a red flag. Don’t forget to get an appraisal for donations of valuable property or if you fail to file Form 8283 for noncash donations over $500 you become an even bigger target. And if you’ve donated a conservation or façade easement to a charity, chances are good that you’ll hear from the IRS. Be sure to keep all your supporting documents, including receipts for cash and property contributions made during the year.
Missing information is another high trigger item. The IRS matches every third-party reporting item to your return. This includes interest income, dividend income, gambling winnings, independent contractor income as well as W-2 income. These are all issued to the IRS so if you fail to include those figures on your return, you will be recognized.
The IRS also targets independent contractors as a way to determine if they’re really contractors or if they’re actually employees. Worker misclassification is an important issue for the IRS and various state taxing authorities because of the perception that many employers are not properly classifying their workers. By avoiding labeling their workers as employees, employers can avoid paying payroll taxes, minimum wages, overtime, health and retirement benefits, and paid leave.
The IRS wants to be sure that owners of traditional IRAs and participants in 401(k)s and other workplace retirement plans are properly reporting and paying tax on distributions. Special attention is being given to payouts before age 59½, which, unless an exception applies, are subject to a 10% penalty on top of the regular income tax. An IRS sampling found that nearly 40% of individuals scrutinized made errors on their income tax returns with respect to retirement payouts, with most of the mistakes coming from taxpayers who didn’t qualify for an exception to the 10% additional tax on early distributions. So, the IRS will be looking at this issue closely. The IRS has a chart listing withdrawals taken before the age of 59½ that escape the 10% penalty, such as payouts made to cover very large medical costs, total and permanent disability of the account owner, or a series of substantially equal payments that run for five years or until age 59½, whichever is later
Filing a large claim for a refund on an amended return will almost always cause an audit. If the original return failed to include an item of income, of course you will want to correct it on an amended return. However, filing an amended return that claims credits that you didn’t claim on the first return will open up the whole return to scrutiny, so you end up being audited on other things not originally at issue.
This is particularly true where the amended return raises new issues. As an example, a return might be amended to claim R&D credits that weren’t on the original return. The IRS is likely to audit for that particular issue, but will open up the entire return for questioning
So, what do you do if you’ve been flagged for an audit? We always recommend discussing with a CPA. Some audits are extremely minor where they may just ask you to pay tax on that 1099 you forgot, and some are more serious. Always know that this is not a personal attack on you and may require some extra explanation. This is why it’s always important to keep your tax return supporting records for at least 3 years from the date you filed your original return or 2 years from the date you paid the tax (whichever is later).