July 29, 2013

Potential Tax Return Audit Red Flags-What They Are and How to Avoid Them

By Chloe D'Agostino, Supervisor, Tax & Business

Potential Tax Return Audit Red Flags-What They Are and How to Avoid Them Tax & Business

Millions of individuals file tax returns but only a small percentage of those returns are examined by the IRS or other taxing authorities. While there should be little reason to worry about an IRS examination, there are a few things that may lead to an increased chance of examination:

High Income Earners
The overall audit rate for individuals found during an IRS study conducted in 2012 is 1.03%. The individual audit rate for taxpayers making $200,000 or more is 3.70% or 1 out of every 27 returns. Make over $1,000,000? The rate jumps to 1-in-8 returns. The more income reflected on your tax return, the more likely it will be for you to have an IRS examination.
Failing to report taxable income
The IRS receives copies of all W-2 and 1099 forms. If your return is missing income that was reported to the IRS on a W-2 or 1099, it is likely that you will automatically receive a notice requesting an explanation.
Charitable deductions
If charitable deductions reported on a return are disproportionately large compared to income, the IRS is likely to investigate. Therefore, it is important to keep all charitable donation receipts. Audit exposure also exists if valuable property is donated without appraisals, or if Form 8283 is not filed when a property donation over $500 is made and the deduction is claimed.
Home office deductions
The home office deduction consists of a portion of rent, mortgage interest, real estate tax payments, insurance, utilities, phone bills and other costs allocated proportionately to an area of an individual’s home used regularly and exclusively for business purposes. The space used to claim the home office deduction cannot also be used as a guest bedroom or play room, nor can the office computer be sometimes used for homework. Therein lays the difficulty in substantiating the deduction. The IRS is aware of the difficulty a taxpayer may have in substantiating a home office deduction and is often successful in knocking down the deduction in part or all together during an audit. (The IRS recently issued new non substantiation guidelines on this deduction, but the amounts are very low.)
Rental Losses
In general, most real estate losses are not currently recognized and are suspended until such time as the taxpayer can recognize real estate rental income. This is known as the passive loss rule. If a taxpayer actively participates in the rental real estate property, an up to $25,000 of losses could be available to offset income, however the deduction begins to fade out as individual’s income reaches $100,000, and is completely phased out at $150,000. Real estate losses are fully deductible for those individuals who are deemed to be real estate professionals. In order to be considered a real estate professional you must spend more than 50% of your working hours and at least 750 hours a year participating in real estate as a developer, broker or landlord. The IRS may pull your return for review to substantiate the claim of real estate professional, especially if your day job is not in real estate.
Deducting business meals, travel and entertainment
Historically, self-employed individuals understate income and overstate deductions. Large deductions for travel, meals and entertainment, especially when compared to income, can cause a closer look from an IRS agent.
100% business vehicle use
Similar to the home office deduction, which requires regular and exclusive use of an area for business use, it is difficult to maintain that a vehicle is used for business and only business purposes. If you are going to be claiming a 100% business vehicle deduction, be sure to maintain detailed mileage logs including details of where and when you went on each trip.
Writing off hobby losses
If you have wage income in addition to large Schedule C losses, there is a high chance your return will be pulled for inspection. Horse breeding and car racing are two such hobbies moonlighting as businesses that can cause scrutiny from an IRS agent. In order for a business to be considered legitimate by the IRS, it must be entered into with the intention of making a profit. If your business reflects profits for 3 out of 5 years (2 out of 7 for horse breeding) it is generally considered a legitimate business intended to make money. If you are audited, you will have to prove you have a legitimate business and not a hobby. Make sure you can support for all expenses.
Running a cash business
Small business owners in cash intensive industries such as taxi drivers, car washes, bars, hair salons and restaurants have historically been a target for IRS examination. Agents are aware that when a good portion of revenue is cash based, there is an opportunity for a taxpayer to underreport income as there is no trail (ie. credit card receipts.)
Failing to report a foreign bank account:
In recent years, there has been greater IRS interest in taxpayers with offshore bank accounts or signature authority, specifically in tax haven countries. In the past, the IRS has set up programs for taxpayers to come forward with previously undisclosed accounts with the incentive of reduced penalties for not reporting sooner, as failure to report a foreign bank account leads to significant penalties.
Engaging in currency transactions
The IRS receives reports of cash transactions in excess of $10,000 involving banks, casinos, car dealerships and other businesses. Banks and other institutions also file reports on suspicious activities such as $9,000 deposits several days in a row. These currency transactions are known to lead to undisclosed income, creating a greater risk of audit examination for those engaging in them.
Taking higher-than-average deductions
If you have deductions that are disproportionately large compared to your income, your return has a higher chance of being reviewed.

While the areas outlined above do present items that will provide greater audit exposure, if you have proper documentation, there should be nothing to worry about in the case of an IRS examination.

Should you have a question related to the points discussed above, contact your Marcum Tax Professional.

Related Service

Tax & Business