Red Flags That Trigger an IRS Audit
The IRS uses a combination of algorithms and human procedures when selecting which tax returns to audit. All tax returns are compared with statistical norms, and those with anomalies receive three levels of review by personnel. Audits then occur either by mail or in meetings at taxpayers’ places of business (or their CPA's). The audits can be pretty unpleasant and are sometimes unavoidable. Some are audit red flags are easy to sidestep, like unreported income. Others, such as high income, can’t be avoided.
Unreported income is probably the easiest red flat to avoid yet the easiest to overlook. Any institution that pays an individual’s income will report it to the IRS, and the more income sources there are, the greater the difficulty in keeping track. Form 1099s and brokerage accounts are commonly overlooked. The IRS matches all income from the tax documents to items in the person’s tax return. If they don’t reconcile, the IRS will automatically conduct at least a letter audit.
Breaking the rules on foreign accounts lead to audits. The Foreign Account Tax Compliance Act has aggressive reporting requirements for foreign bank accounts. The law requires overseas banks to identify American asset holders and provide information to the IRS. Individuals must report foreign assets worth at least $50,000 on the new Form 8938. You also have to identify the institution and the highest dollar amount the account was at the previous year. Because of a perception that people with foreign accounts are trying to hide something, the regulations demand transparency which in turn increases the likelihood of an audit.
Blurring the lines between personal and business expenses can lead to audits. The IRS will give a close look to excessive business tax deductions . The agency uses occupational codes to measure typical amounts of travel by profession, and a tax return showing 20% or more above the norm might get a second look. In general, the IRS can be very particular about mixing business and personal expenses. Meals and entertainment can be allowable, but exceeding the occupational norm by a great amount invites an audit. Meals and entertainment oftentimes can be a blurred line, and the IRS doesn’t like any blurred lines.
Earning more than $200,000 can lead to an audit. Last year the IRS audited about 1% of those earning less than $200,000, and almost 4% of those earning more, according to IRS data. Raise the threshold to $1 million and the percentage of audited tax returns increases to 12.5%. The same patterns exist when it comes to business tax returns: 1% of corporations with less than $10 million in assets, compared with 17.6% above that threshold. The IRS isn’t haphazardly picking on high earners, rather, the IRS is applying the rule of big numbers. If people make more money, there is a better likelihood of a finding an audit claim. Either way, having a solid CPA preparing your tax returns will help you win your audits if you find yourself in one.