Top 10 Tax Audit Red Flags & Understand How To Avoid an IRS Audit
Did you know that the IRS assigns a numeric tax score to every return they receive? Scores that are higher than a predetermined number are closely reviewed and considered for an audit. Additionally, the IRS has a complex matching system which matches third party documents with the information you provide them; any differences are typically examined. For this reason, you need to be aware of the IRS processes that trigger red flags and the most common audit flags.
Discriminant Function System (DIF)
One of the main methods the IRS uses in choosing which tax returns are going to be audited is through a computer program called the Discriminant Inventory Function System. This system performs statistical analysis on each tax return based on many different factors and will sort out the tax returns that likely contain errors, which will result in a change in the tax liability that is owed. Unfortunately, this system gets more and more complex with each passing year and people who used to evade the IRS now have a lower probability. The system goes as far as comparing your income with similar professions in the same geographic location to ensure the income your reported is about equal.
IRS Matching System
The IRS also correlates the information you provide them with third party documentation that is received. For example, if you receive a W-2 or 1099, it is required that the person who provided you with the W-2 or 1099 also report that information to the IRS. Once the IRS receives your information and the third party documentation, they will begin the matching process. This ensures that individuals do not avoid reporting income they received for work they did.
Now that you understand the methods used by the IRS to determine which tax returns to select for audit, below are several tax audit red flags that trigger a high DIF or throws off their tax information matching process:
- Large change in income: The IRS believes that your income should be consistent from one year to the next, for the most part. If there are large changes in income, that cannot be backed up by your 1099s or W-2s, this is a major audit red flag. Of course, there is nothing wrong with these changes if it can be supported with the proper documentation.
- Rounded numbers: It is very unlikely that your mortgage interest, for example, will be a round number. If you are in the habit of rounding every number, the IRS is going to view this highly suspicious. Simply stated, if you are rounding some numbers, the IRS believes that you are probably doing this with your return.
- Charitable donations: While the IRS accepts donations, and they are a great way of lowering your tax liability, it is important that you do not abuse the system. The IRS has found over the years that many people embellish their donations. They know what the average donation is for a person in your income bracket, and keep this in mind as your return is “scored.”
- Those earning more than $100k: Earning as much money as you can is a goal that you share with many Americans. But did you know that those who earn more than $100k/year are 500 percent more likely to be audited? This is one of those loopholes in this income bracket, which you cannot change. Basically, it is a fact that the IRS audits taxpayers with a higher income at a higher rate.
- Job expenses: In most cases, if you are a W-2 employee you do not have the right to deduct job expenses. That being said, there are certain cases when this may be true. You must meet the following guidelines: total of all expenses exceeds two percent of your adjusted gross income; the expenses are deemed “ordinary and necessary”; and the expenses were not reimbursed. The IRS knows that most people do not meet these standards. In turn, this is a huge red flag anytime it is included on a tax return.
- Low income for your profession: The IRS knows how much somebody in your field earns on average. If you report income that is significantly less than this number, the IRS is going to throw up a red flag. If you get audited, but you did report all income, it may be time to ask for an increase in annual pay.
- Different information on your state and federal return: This is a no-brainer, but something that many people overlook. If the information you supply on your state and federal return are not the same, it goes without saying that you can expect red flags to be triggered all over your tax return. You must guarantee your information is consistent on both returns.
- Unreported income: The IRS makes it increasingly difficult for people to eschew reporting income each year, by preventing businesses in reporting the deduction of payment without providing proof of who received the payment. Some common income people fail to report are gambling winnings, investment income, dividend income, and 1099 income.
- High income: The IRS tends to audit individuals that make over one hundred thousand a year about 5 times more than individuals under this figure. It is vital for those in the higher tax brackets to be diligent in their documentation.
- Consistent Business losses: The IRS has a rule that you cannot deduct losses from a hobby on your tax return. You must be in business with the intent of making a profit. If the IRS deems that your “business” is actually a hobby, they will disallow the deductions. Typically losses from a business will trigger this flag and cause for further investigation.
Make sure you watch out for these ten tax audit red flags the next time you are filing a return or thinking about which documentation is important to save.
This guest post was provided by Manny Davis, a tax writer that provides his readers with IRS tax tips, news, guidance and more. His website guides people through various tax problems including tax penalties, unfiled tax returns, tax levies and more.