Certain red flags in a tax return are sure to draw scrutiny by the IRS. Some are easy to sidestep. Others, can't be helped.
Key Takeaways
- The IRS uses a combination of automated and human processes to select which tax returns to audit.
- Not reporting all of your income is an easy-to-avoid red flag that can lead to an audit.
- Taking excessive business tax deductions and mixing business and personal expenses can lead to an audit.
- The IRS mostly audits tax returns of those earning more than $200,000 and corporations with more than $10 million in assets.
Red flags
The Internal Revenue Service uses a combination of automated and human processes when selecting which tax returns to audit. All tax returns are compared with statistical norms, and those with anomalies undergo three layers of review by personnel.
Audits then occur either by mail or in meetings at taxpayers’ places of business. They can be unpleasant and are sometimes unavoidable. Certain red flags are sure to draw scrutiny and some are easy to sidestep—unreported income, for example. Others, such as high income, can’t be helped.
1. Not reporting all of your income
Unreported income is perhaps the easiest-to-avoid red flag and, by the same token, the easiest to overlook. Any institution that distributes an individual’s income will report it to the IRS, and the more income sources you have, the greater the difficulty in keeping track.
Old brokerage accounts are commonly overlooked, as are Form 1099s and distributions from a college savings account to pay tuition.
- The IRS will typically receive a copy of all the tax forms that you do, including distributed income.
- The IRS will match the reported items to a person’s return. If they see something missing, they will automatically conduct at least a letter audit.
2. Breaking the rules on foreign accounts
The Foreign Account Tax Compliance Act has strict reporting requirements for foreign bank accounts.
- The law requires overseas banks to identify American asset holders and provide information to the IRS.
- Individuals are required to report foreign assets worth at least $50,000 on the new Form 8938.
It used to be you didn’t have to report it; you just had to check a box that you had one. Now you have to not only check the box, you have to identify the institution and the highest dollar amount the account was at the previous year.
The regulations demand openness, which in turn increases the likelihood of an audit. That’s because of a perception that taxpayers with foreign accounts are trying to hide income offshore.
- But it’s a Catch-22: Compliance with the law increases the likelihood of an audit, and noncompliance can result in stiff penalties and significant legal liabilities.
3. Blurring the lines on business expenses
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.
- Also, take-home vehicles aren’t considered strictly business, so a specific purpose should accompany any vehicle-related deduction.
Generally speaking, the IRS can be strict about mixing business and personal expenses. Business meals can be allowable, but exceeding the occupational norm by a great amount invites an audit. Business meals oftentimes can be a blurred line, so be sure to document what is and isn't a personal expense.
TurboTax Tip:
Individuals must report foreign assets worth at least $50,000 on the new Form 8938. Failing to report foreign assets can lead to an audit.
4. Earning more than $200,000
Last year the IRS audited about 1% of those earning less than $200,000, and almost 4% of those earning more, according 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.
Higher incomes are likely to result in more complex tax returns that are more likely to contain audit triggers. More importantly, the IRS wants to maximize return on investment, something the agency gets better at every year:
- $55.2 billion was collected through enforcement activities last year, a 63.8% increase since 2001 without adjusting for inflation.
- But enforcement personnel increased only 9.8% during that time.
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FAQs
Some red flags for an audit are round numbers, missing income, excessive deductions or credits, unreported income and refundable tax credits. The best defense is proper documentation and receipts, tax experts say.
What are red flags for an IRS audit? ›
Not reporting all of your income is an easy-to-avoid red flag that can lead to an audit. Taking excessive business tax deductions and mixing business and personal expenses can lead to an audit. The IRS mostly audits tax returns of those earning more than $200,000 and corporations with more than $10 million in assets.
What usually triggers an IRS audit? ›
Taxable income that is not reported on your tax return is likely to trigger an IRS audit. Common kinds of unreported income include: Income from a hobby or side hustle.
What are signs of being audited by IRS? ›
If the IRS decides to audit, or “examine” a taxpayer's return, that taxpayer will receive written notification from the IRS. The IRS sends written notification to the taxpayer's or business's last known address of record. Alternatively, IRS correspondence may be sent to the taxpayer's tax preparer.
Who gets audited by the IRS the most? ›
The taxpayers most likely to be audited are those with annual incomes exceeding $10 million — about 2.4% of those returns were audited in 2020. But the second most likely group to get audited are low- and moderate-income taxpayers who claim the Earned Income Tax Credit, or EITC.
What looks suspicious to the IRS? ›
Too many deductions taken are the most common self-employed audit red flags. The IRS will examine whether you are running a legitimate business and making a profit or just making a bit of money from your hobby. Be sure to keep receipts and document all expenses as it can make things a bit ore awkward if you don't.
What does a typical IRS audit look like? ›
The IRS manages audits either by mail or through an in-person interview to review your records. The interview may be at an IRS office (office audit) or at the taxpayer's home, place of business, or accountant's office (field audit). Remember, you will be contacted initially by mail.
How does the IRS decide who gets audited? ›
The Unreported Income DIF (UIDIF) score rates the return for the potential of unreported income. IRS personnel screen the highest-scoring returns, selecting some for audit and identifying the items on these returns that are most likely to need review.
How far back can the IRS audit you? ›
As provided by the IRS: “Generally, the IRS can include returns filed within the last three years in an audit. If we identify a substantial error, we may add additional years. We usually don't go back more than the last six years.
Does a large refund trigger an audit? ›
Does a Large Refund Trigger an Audit? Not necessarily. But if the refund is a result of fraudulent claims, such as inaccurately reporting income or claiming deductions you're not actually eligible for, then it can trigger an IRS audit.
If you are audited and found guilty of tax evasion or tax avoidance, you may face a fine of up to $100,000 and be guilty of a felony as provided under Section 7201 of the tax code.
How to prove head of household if audited? ›
First, you'll need to show that you provide more than half of the financial support for a dependent, like a child or your elderly parent. To prove this, just keep records of household bills, mortgage payments, property taxes, food and other necessary expenses you pay for.
Can you be audited after refund is approved? ›
While you might assume you can't be audited if you've already received money back from your taxes, that's a misconception. You can.
What raises red flags with the IRS? ›
Taking unusually large deductions
So, if you claim a large deduction that doesn't make sense for someone in your income range, the IRS computers are going to flag that deduction. For example, if you make $50,000 during the year, the IRS is going to be suspicious if you claim $20,000 in donations to charity.
What happens if you get audited and don't have receipts? ›
You can claim expenses spent on running your business without a receipts but cannot claim IRS deductions on personal costs. In an IRS audit no receipts situation, you cannot claim entertainment expenses, non-essential renovations, or charitable contributions not for your business purposes.
How do I know if my tax return has been flagged? ›
If the IRS decides that your return merits a second glance, you'll be issued a CP05 Notice. This notice lets you know that your return is being reviewed to verify any or all of the following: Your income. Your tax withholding.
What is considered a red flag in an audit? ›
Red flags are condition(s) that can be observed through the audit process. They are associated with the fraud risk statement. The conditions are found in data, documents, controls, or behaviors. It is important to note that the ability to observe the condition will be impacted by the sophistication of concealment.
How serious is an IRS audit? ›
On a scale of 1 to 10 (10 being the worst), being audited by the IRS could be a 10. Audits can be bad and can result in a significant tax bill. But remember – you shouldn't panic. There are different kinds of audits, some minor and some extensive, and they all follow a set of defined rules.
Does the IRS check your bank account? ›
The IRS probably already knows about many of your financial accounts, and the IRS can get information on how much is there. But, in reality, the IRS rarely digs deeper into your bank and financial accounts unless you're being audited or the IRS is collecting back taxes from you.
