We now know that the IRS audit rate dropped to 0.4% of all individual tax returns. That works out to approximately one return out of every 250 filed — and most were low-level correspondence audits. The IRS is auditing fewer returns due to federal budget cuts, and because it has not yet replaced experienced auditors who have retired.

Still, that doesn’t mean you can drop your guard when it comes time to file your return. When returns are filed, they’re scanned into the IRS computer system, which is designed to detect anomalies. If there is an anomaly, that creates a “red flag.” The IRS is more likely to eyeball your return if you claim certain tax breaks, deductions, or credit amounts that are unusually high compared to national standards; you are engaged in certain businesses; or you own foreign assets.

It’s impossible to predict if your return will be selected for an audit, but you would do well to keep the most common red flags in mind:

1. Failing to report all taxable income

Over the years the IRS has received more information from third parties — not only from W2s, 1099s, and brokerage statement information, but also from flow through entities. The computer system compares that information to the return. If there is a mismatch, the computer generates a bill.

2. Earn a lot or very little

The more you earn, the higher the chance the return will be audited. The majority of returns audited are from taxpayers who earn more than $500,000. The IRS has limited staff, and if there is a change on a wealthy taxpayer’s return as a result of an audit the money owed will be greater and the possibility of collection rises. On the other end of the spectrum, taxpayers who reported no adjusted gross income are also flagged, and the audit rate for this group is approximately 2%. The IRS may do a cost-of-living analysis to see how you were able to live on hardly any income. Again, that’s much higher than other income levels.

3. Excessive deductions or credits

The IRS will compare the itemized deductions and credits taken to the average totals for similar taxpayers in the same income bracket. If yours is higher, the IRS may look at the numbers more carefully.

4. Schedule C filers

Sole proprietors and freelancers are entitled to a handful of deductions that most other taxpayers cannot claim, such as home office deductions, mileage expenses, meals, and entertainment expenses — and IRS agents know that self-employed individuals tend to claim excessive deductions. Schedule C filers also sometimes under-report income, so the IRS looks closely at businesses that primarily operate with cash or show a loss. For those businesses, the audit rate in 2019 was between .08% and 1.6%.

5. Non-filers

Addressing high-income non-filers is now the IRS’s top strategic priority. The emphasis is on individuals who earned more than $100,000 but did not file a tax return. As previously mentioned, the IRS compares information they receive from multiple sources to see if returns were filed

6. Claiming 100% business use of a vehicle

The IRS knows that it is rare for someone to use a vehicle for business purposes 100% of the time, especially if they don’t own another vehicle for personal use. The IRS also targets heavy SUVs and large trucks used for business because these vehicles are eligible for more favorable depreciation and expensing provisions. The higher the business use percentage, the greater the IRS scrutiny will be.

7. Claiming a loss on a hobby

You can take a loss on a business, but you cannot claim a loss for a hobby. For a business, the reasonable expectation is to make a profit three out of every five years. If you have a hobby that is set up as a business, make sure to keep supporting documents for income and expenses. If you have multiple years of losses on your Schedule C and you have a lot of income from other sources, the IRS will look at this activity more as a hobby — particularly if you do not depend on the income to make ends meet, or you do not devote the necessary time, effort, and money to maximizing your profits.

8. Home office deduction

Due to the COVID-19 pandemic, many people worked from home in 2020. But most people will not be able to claim the deduction because it’s not available to employees. Prior to 2018, certain employees were able to claim the home office deduction as a non-reimbursed business expense subject to 2% of adjusted gross income

The deduction is still available to self-employed individuals and independent contractors who use a room or space “regularly and exclusively for business.” You do not need to own a home — renters can also claim the deduction. You can claim the deduction through actual expenses incurred, or use a simplified method, which is limited to $5 per square foot with a maximum deduction $1,500

9. Taking an early payout from an IRA or 401(k) account

Special attention is given to payouts before age 59½. Unless an exception applies, these withdrawals are subject to a 10% penalty on top of regular income tax. With so many jobs eliminated in 2020, a lot of people took money out of their retirement accounts

10. Engaging in virtual currency transactions

The IRS using pretty much everything in its arsenal to trace activities of taxpayers who sell, receive, and trade or otherwise deal in bitcoin or other virtual currency. There is now a question on page one of the 1040 return asking about virtual currency activity.

11. Failing to report a foreign bank account

This has been an issue for many years, particularly with taxpayers who have money in nations with more favorable tax laws than the United States. Some foreign banks are obligated to provide the IRS with lists of American clients. There is also a question on Schedule B about foreign bank accounts. If you have more than $10,000 in a foreign account, you are required to file FinCEN Form 114. Foreign assets that amount to more than $50,000 must be reported on IRS Form 8938

12. Claiming the American Opportunity Tax Credit (AOTC)

The cost of a college education continues to rise faster than the cost of inflation. The AOTC is worth up to $2,500 per student for the first four years of college. Forty percent of the credit is refundable, meaning that even if you don’t owe any tax, you get the money back. There are income limitations, and the student must be enrolled at least half-time. Eligible expenses include tuition and books and required fees, but do not include room and board.

You’ll run into trouble if you take the credit for more than four years, omit the school’s ID number on Form 8863, or take the credit without being eligible

13. Engaging in cash transactions

Under the Bank Secrecy Act, various types of cash transactions in excess of $10,000 are required to be reported. The goal is to thwart illegal activities. So, if you make large cash purchases or deposits, be prepared for IRS scrutiny

Conclusion

The above list is not intended to be all inclusive; it’s simply to make you more aware of certain activities can lead to IRS audits. Working with us can help mitigate the risk of being audited — and if you are audited, we are here to help defend you against any potential adverse adjustment.

Please contact us if you have any questions.