IRS audits may be a concern for many Americans, with high-net-worth individuals often facing even greater scrutiny from the IRS. Below, we’ll look at what an audit entails and highlight common reasons why Americans are getting audited. Although no one can be completely immune from IRS examination, understanding processes and potential audit triggers can help taxpayers better understand compliance and prepare for potential audits.
What is an IRS audit?
An IRS audit is a meticulous review of financial records and tax filings to ensure compliance with current tax laws and regulations, including reported income, deductions, and credits. Depending on the size and scale of your tax return, the length of an audit can vary from a few short weeks or even months long.
How far back can the IRS audit you?
Generally, the IRS adheres to a three-year statute of limitations for tax audits. This means that they can review your tax returns for the three years preceding the current tax year. However, certain circumstances can extend this period to six years, usually if there is a substantial underreporting of income. In cases of fraud or failure to file a return, there is no time limit.
Who gets audited by the IRS the most?
The overall odds of an IRS audit are low, about 4 out of every 1,000 returns. However, high-net-worth individuals are more likely to be targeted due to complex income sources, large deductions, and sophisticated financial structures. Self-employed people and those claiming the Earned Income Tax Credit (EITC) are also statistically more prone to facing IRS scrutiny.
What are IRS audit triggers?
IRS audit triggers serve as specific events or patterns that may prompt the IRS to conduct a closer examination of your tax return. Recognizing these triggers is crucial for individuals and businesses hoping to avoid unnecessary scrutiny. However, some audits are done on a random basis, so even if you have no common triggers on your return, you still could be subject to an audit (even though the chances are lower).
10 IRS audit triggers
Below are 10 of the most common triggers for IRS audits. Keep in mind, this isn’t the end of the list — there are many other potential audit triggers depending on a taxpayer’s particular situation.
1. Large charitable donations
The IRS can reference data providing average charitable deductions based on various income levels. If you’re above average for your category, you might call attention to yourself. This is especially true if you’ve deducted charitable gifts of appreciated property. To avoid this red flag, make sure your donations are all properly substantiated, including by independent appraisals if required.
2. Gambling losses
Generally, you can deduct losses up to the amount of your winnings on your personal return, but you must have proof to back up your claims. If your gambling activities rise to the level of professional gambler, you might be able to deduct a loss from other income, but the IRS often contests this tax treatment.
3. Unreported income
It’s easy to miss income that might fall through the cracks, such as interest and dividends as well as non-employee compensation from Form 1099-NEC. If you fail to report the income, the IRS may uncover a discrepancy with the forms it receives. Be sure to give your tax professional all forms you receive.
4. Rental income and deductions
You don’t want the IRS to find that you played fast and loose with the rules for rental properties. Showing a loss for the year despite a high rental rate or charging below-market rent could trigger an inquiry. Generally, you may use up to $25,000 of loss to offset income from non-passive activities, but you must meet specific participation requirements. Check with your tax advisor to see if you’re on firm ground.
5. Home office deductions
If you regularly and exclusively use a portion of your home for your business, you may be able to deduct the expenses and depreciation associated with the space. Usually, the greater the business percentage claimed for use of the home, the greater the audit risk. Employees who work from home (as opposed to self-employed people) currently can’t claim a home office deduction. Now that more people are working from home, the IRS may look for taxpayers trying to bend the rules.
6. Casualty losses
Despite recent legislative changes restricting casualty loss deductions, you can still write off losses to personal property sustained in a federally designated disaster area. But be aware that the IRS may scrutinize appraisals to determine if you’re inflating a disaster-area loss.
7. Business vehicle expenses
The IRS often flags tax returns with large deductions for business vehicles, especially if they reflect double-digit depreciation allowances. Put simply, you’re required to keep a contemporaneous log of your driving activities, along with proper substantiation. To withstand any challenges from the IRS, keep a detailed record of your deductions or use an app like MileIQ or TripLog to automatically track your mileage and simplify your reporting.
8. Cryptocurrency transactions
Cryptocurrency is still a relatively new potential audit target. The IRS now specifically asks on your return if you’ve bought or sold cryptocurrency. If you’ve answered yes, be prepared to substantiate the transaction information.
9. Day trading activities
Most taxpayers offset capital gains and losses from securities sales on Schedule D of their personal tax returns. But claiming to be a “day trader” may help you benefit from favorable tax provisions, including deductions for specific expenses. If you do this, consult with your tax advisor to ensure you’re ready to respond to any IRS inquiries.
10. Foreign bank accounts
Checking the box on Schedule B that indicates you have a foreign bank account could increase your chances of an audit. Conversely, failing to check the box when you should do so may
also trigger an audit. The IRS matches up information it receives on foreign bank accounts. Generally, a taxpayer must file a Report of Foreign Bank and Financial Accounts (FBAR) if the aggregate value of assets in foreign bank accounts exceeded $10,000 during the prior year.
IRS audit process: What happens if the IRS audits you?
Of course, with proper tax reporting and professional help, you can reduce the likelihood of triggering an audit. The most important thing for taxpayers to do is keep relevant and easy-to-access records of their financial history going back at least three years. Although you may be able to stand up to the scrutiny, it’s wise to seek assistance from an experienced accounting firm, which can provide invaluable support with both IRS audit representation and prevention.