Is Your Tax Return a Red Flag? Top 13 IRS Audit Triggers
Nothing about filing a tax return is pleasant, and the possibility of being audited by the IRS worsens it. Even if you think you’ve been 100% accurate when filing your taxes, it’s nerve-wracking and time-consuming to go through an audit. Just as you brush your teeth regularly to reduce the chance of needing painful dental work, you can avoid things that may prompt the IRS to contact you (which is worse than sitting in the dentist’s chair).
This article covers 13 things seen on tax returns that are likely to trigger an IRS audit. None of them are illegal (certainly not #1), but they will likely bring on a second look from the IRS. In no particular order:
1. Earning a lot of money – This is not a bad thing! High earners are more likely to get audited, even without any red flags in the return. The IRS has been given funding to hire more auditors to go after tax cheats and has firmly stated that it will not be focusing on individuals with incomes below $400,000. If you make more than that, take extra care with #2 through #13 on this list.
2. An incorrect or incomplete return – Many people think they can do their taxes, especially those with only income reported on a W-2 or a couple of 1099s. Unless you are familiar with the specific and nuanced vocabulary of taxes and investments, it’s easy for intelligent people to make mistakes that can trigger an audit. Consider hiring a pro—if your return is straightforward, then firms like H&R Block may be able to meet your needs.
It’s essential to remember that anyone with investments could receive an amended Form 1099 at any time up to March 31st. If that changes your investment income and you filed your return early (to get it over with), then you should file an amended return; otherwise, your return won’t match your final 1099, and that’s not what the IRS wants to see. This common pitfall is easily avoidable. Prepare all your documents but wait until April 1st to see if your custodian provided any amended tax documents before finalizing and submitting your return.
3. Claiming large charitable donations – The threat of an IRS audit should never be enough to dissuade someone from making a large donation. However, it is possible your contribution could trigger an audit. This is particularly true if you made large non-cash donations (such as vehicles, artwork, etc.). Get a written acknowledgment from the charitable organization for all donations with a value greater than $250. For substantial gifts other than cash or securities, get a professional appraisal and keep it with your tax records.
Suppose you are selling a business or other highly appreciated asset this year. In that case, you may want to reduce a large tax bill from the sale proceeds by combining charitable donations that you would otherwise spread out over several years. While this is all legitimate, it may flag an audit. People often use a donor-advised fund (DAF) to make these “bunched” contributions, and the DAF will keep tax records. Otherwise, work with a qualified tax expert.
4. Failing to report all of your income – The IRS receives copies of the tax documents that employers, brokerage firms, limited partnerships, and others send you (Forms 1099, W-2, K-1, etc.) If the IRS sees something there that is not included on your tax return, it dramatically increases your chance of being audited. Ensure you don’t forget to collect any tax documents from your bank and investment accounts. It’s surprisingly common for people to forget one or multiple holdings/accounts from various institutions.
5. Claiming a home office deduction – Many people claimed a home office deduction years ago because they brought their work home. That doesn’t work anymore (excuse the puny pun). This deduction only applies if you are self-employed or run a small business from home. Even then, you must have a specific place in your home used exclusively for work (if you teach yoga from home via Zoom but use that space as a living room, it doesn’t qualify). The IRS can get very nit-picky about this, so if only a small amount of square footage is involved, it may not be worth it.
6. Claiming significant business expenses to generate a net operating loss - Any business that generates revenue but operates at a loss is likely to get a second look from the IRS. Physicians in private practice might report a net operating loss from amortizing the cost of new equipment. This reporting is often done intentionally; just be sure to work with a qualified tax professional in this situation.
7. Not paying yourself an appropriate wage – Owners of businesses organized as an LLC or S-Corp may be tempted to pay themselves a low salary to claim more of the profits on their personal tax returns and avoid paying certain payroll taxes. The IRS is looking for this and expects business owners to pay themselves a reasonable salary. Don’t risk an IRS audit; seek input from a tax pro.
8. Owning crypto or other digital assets – Buying or selling Bitcoin or other cryptocurrencies, or non-fungible tokens, etc., is a hot topic for the IRS. Form 1040 now asks whether you have engaged in any transactions involving these assets. If you say “yes,” be prepared to show proof of your transactions and the gains/losses generated (if you answer “no” but should say “yes,” that’s tax fraud). Some crypto platforms and “wallets” now require your social security number to open an account, and the IRS can trace transactions. NOTE: If a crypto platform or exchange paid you interest but is now bankrupt or in financial distress, and your crypto is locked up, you still owe taxes on that interest. The IRS is increasing enforcement in this arena.
9. Claiming a hobby as a business – Deducting business expenses is fine, but it has to be a real business, not a hobby. Admittedly, there can be a fuzzy line between the two. Generally speaking, if a business has not shown a profit in at least three out of five years, the IRS will view it as a hobby. That limits what you can deduct for expenses related to those activities. If you make birdhouses or knit sweaters and people occasionally pay you to make one for them, don’t try to deduct the cost of materials to save a few dollars off your taxes.
10. Owning financial assets outside the U.S. – If the IRS suspects that you have $10,000 or more in one or more foreign financial accounts and you have not filed a Foreign Bank Account Report (FBAR), or if they suspect you misreported assets or income on the FBAR, that could trigger an audit. This type of audit can be complex — failing to comply with FBAR reporting requirements can involve civil penalties and criminal prosecution. Owning real estate outside the U.S. may also be a flag. NOTE: Many mutual funds and ETFs hold foreign stocks or bonds, and that’s not a problem – this will be listed on your 1099 and will flow right into your return.
11. Abusive tax shelters – There is no strict definition of an abusive tax shelter, but it probably is if it sounds too good to be true. These strategies are typically promoted solely for tax benefits and do not generate cash flow or capital gains for investors. A now-defunct example of this is the strategy of passing assets to a second generation (grandchildren) to avoid estate taxes for the first generation (children). The IRS quickly turned its ever-watchful gaze to this loophole and instituted the Generation-Skipping Transfer Tax (GSTT), effectively ending the practice. At the time, it was commonplace but is now considered abusive.
The IRS will always be wary of strategies that are said to exploit a “loophole” in the tax code. For example, an overuse of charitable remainder annuity trusts (CRAT) may also fall into this category. You may want to revisit positions you have taken on a past tax return concerning questionable types of transactions (and avoid entering into these transactions in the first place). The IRS eventually tracks these down and imposes steep penalties on those involved.
12. Claiming Losses on Rental Properties - People who own rental properties often try to claim excessive expenses to minimize taxable income or generate a loss. Depreciation is a legitimate expense that reduces income from rental properties, but if your tax return consistently shows losses from those properties, that is an IRS audit trigger.
13. Hardship withdrawals from retirement accounts – The list of things that qualify as a hardship for this purpose is limited. For example, you can withdraw $10,000 from a Roth to help finance the purchase of your first home, but you have to prove it is your first home. Severe medical hardships may also qualify.
What is the statistical likelihood of being audited? Very small. According to TRAC at Syracuse University, the odds that a typical taxpayer who reports income of less than $200,000 will undergo an audit was just 0.19% in 2022. Those with a higher income have a higher chance (0.49%), and for higher earners whose returns include Schedules C or F (nonfarm and farm revenue), the odds rise to 1.03%. Millionaires had the highest odds of being audited, but often via “correspondence” (requiring more documentation, sent by mail). Only 1.1% of millionaires went through an in-person audit in 2022. Be sure to reach out to your advisor and tax specialist with any questions specific to your situation.
This post is for informational purposes only and is not intended to be a solicitation or substitute for individualized investment advice. Information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies. Past performance is no guarantee of future results. Advisory services offered through Gold Medal Waters, a Registered Investment Advisor.