Ever wonder why some tax returns are audited by the IRS while most are ignored? IRS audited less than 1% (actually 0.7%) individual tax returns in 2016. That said, your chances of being audited by IRS increases depending upon various factors, including your income level, types of deductions or losses claimed, business in which you're engaged, if you own foreign assets as well as math errors in the tax return. Although there's no sure way to avoid an IRS audit, here are some of the main red flags that could increase your chances of IRS Audit.
1. Income Level: IRS statistics show that people with incomes of $200K or higher had an audit rate of 1.7% (more than twice of average audit rate) and people with incomes of $1 million or higher had an audit rate of 5.8%.
2. Not reporting ALL income: IRS gets copies of all 1099s and W-2s you receive, so make sure you report all income on your return. A mismatch sends up a red flag and causes the IRS to review a return.
3. Rental Losses: IRS actively scrutinizes rental real estate losses that are claimed for active participation, especially those written off by taxpayers who have W-2 income and/or other non-real estate Schedule C businesses income.
4. Business Meals Travel & Entertainment: Schedule C is the most audited schedule by IRS. Historically IRS shows that most under-reporting of income and overstating of deductions are done by those who are self-employed. A large write-off for meals, travel, and entertainment will set off the alarm, especially if the amount seems high for that business.
5. 100% business use of Vehicle: Claiming 100% business use of an automobile is red meat for IRS agents. IRS agents are trained to focus on this issue and will scrutinize your records. Make sure you keep detailed and precise records.
6. Hobby Losses: You must report any income you earn from a hobby, and you can deduct expenses up to the level of that income only. The law bans writing off losses from a hobby. For you to claim a loss, your activity must be entered into and conducted as the business with the reasonable expectation of making a profit.
7. Home Office Deduction: To take advantage of this tax benefit, you must use the space exclusively and regularly as your principal place of business. If you qualify, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance and other costs that are properly allocated to the home office. Alternatively, you have a simplified option for claiming this deduction: The write-off can be based on a standard rate of $5 per square foot of space used for business, with a maximum deduction of $1,500.
8. Cash Intensive Business: Small business owners in cash-intensive businesses e.g. taxi, car washes, bars, hair salons, restaurants are a tempting target for IRS auditors. Experience shows that those who receive primarily cash are less likely to accurately report all of their taxable income, so IRS agents are trained to determine average cash collected by each business by region.
9. I would like to emphasize that everyone's situation is different so it's important to fully consider your specific situation before claiming a particular expense. The list does not guarantee that a person will (not) be audited, and most agencies and tax courts typically look at the totality of the circumstances to determine if a tax return should be audited, but the list is very helpful in understanding the thought process.