Although you may someday be at the center of an audit, some tax returns attract more IRS attention than others.
While some red flags for the IRS are outside the taxpayer’s control — such as large swings in income because of a promotion or change in the industry — by ensuring your information is reported accurately, you can reduce your chances for an audit. Here are six areas where taxpayers can take control to help maintain a low-stress filing season.
Underreporting your income
One of the most common ways tax returns end up getting flagged is when a taxpayer fails to report all their income. Although you’re unlikely to miss the larger parts of your taxable income when you’re filing for the tax year, you might forget about the smaller ones, such as 1099-INT for interest earned on savings accounts or CDs, 1099-DIV for dividends and distributions, or 1099-R for retirement plan distributions.
1099s are required to be sent out by the issuers at the end of January each calendar year. If you’re still missing documentation by the end of February — and have already tried reaching out to the person or company who paid you — you can check ID.me to see if a copy was issued to the IRS.
Excessive business expenses
For the IRS, blurring the lines of business and personal expenses is a red flag. Although many of the costs associated with running a business are tax deductible, the following are not:
- Personal expenses, such as clothing, haircuts, personal meals, and general travel
- Commuting costs and non-business travel, such as vacations
- Fines and penalties incurred personally or through business activities
- Expenses related to hobbies that do not generate income (more on that below)
Generally, the IRS says a qualified deductible expense must be both “ordinary and necessary.” An “ordinary” expense is one common and accepted in your industry, and a “necessary” expense is helpful and appropriate for your business. So, although the clothes you wear to work in an office do not qualify, uniforms for a restaurant would. Additionally, although a business meeting may have been taken alongside a meal, business owners need to keep detailed records of the amount, who attended, and the nature of the meeting.
If you feel as though some of your expenses should be counted as business expenses but are not sure, you should always consult with a CPA.
Hobby losses
A hobby loss occurs when a person reports a financial loss from an activity the IRS views as a hobby rather than a business. While hobbies can generate income, they are usually pursued more for pleasure than for profit. If an activity hasn't made a profit in three of the last five years, it might be considered a hobby.
Hobby losses can attract IRS attention because they might suggest the taxpayer is deducting personal expenses as business expenses. To avoid this, taxpayers should clearly differentiate between hobby and business activities. Maintaining accurate records and demonstrating a profit motive can help ensure filings do not trigger an audit.
Charitable contributions
Charitable contributions to qualified organizations can be tax deductible if you itemize your return. Reporting actual, unrounded numbers is vital — and you can only do that if you keep receipts and detailed records of your charitable donations. It’s on the donor to save and compile proper documentation for their donations. Even if an organization has not sent you a receipt, you should request one; if they can’t provide one, you must keep track of what, when, and to whom something was donated (especially if it’s not just a cash donation).
The IRS requires written, contemporaneous documentation for any contribution over $250 in cash or $500 for non-cash items. For non-cash items valued at over $5,000, there must also be an expert appraisal.
Math mistakes and round numbers
Accuracy is key when filing your returns, and gross estimations or math mistakes can be flagged by the IRS. When completing a tax return, always make sure you have evidence of any deductions you’re taking. Using real numbers with receipts to back up those numbers helps to avoid triggering an audit.
Even if your return is being filed by an accountant, taxpayers should always review their work. Although they may have filed everything correctly with the numbers you provided, another review of your return may reveal areas where you originally missed or incorrectly recorded some important numbers.
While high earners are more likely to face an IRS audit, maintaining documentation and remaining accurate in your reporting should help to decrease your chances of being chosen for examination. Taxpayers should keep records for their tax returns for seven years from the date you filed your return or six years from the date the tax was paid — whichever was later. (For certain situations, such as claiming deductions for losses from worthless securities or bad debt, the IRS recommends keeping records for longer.)
If you have questions about avoiding IRS audits, reach out to your trusted Mowery & Schoenfeld tax partner.