Few things drum up worry in the minds of Americans quite like a tax audit. Those two words are all it takes for law abiding citizens to start looking over their shoulders like they’re in an episode of The Sopranos.
The truth is, less than 1% of returns are audited in any given year. With bureaucracy and government funding being what it is, that number likely will not increase much in the coming years. Despite what you may feel, if you are making good faith efforts and file accurate, fairly vanilla tax returns, the IRS isn’t breathing down your neck.
Despite the odds, it’s not inconceivable that you might get pulled for an audit one day. Let’s take a look at some of the red flags that may lead to an audit, and what you should be doing to remedy them.
What IRS Agents Look For:
When IRS agents are determining whose file merits a closer inspection, it is most likely because one of their red flags has been tripped. It all boils down to information that stands out from the average of other tax payers in your demographic, industry, region, etc. The algorithms and systems they use aren’t perfect, of course, but they greatly help systematize what agents should keep an eye out for.
Do you take higher-than-average deductions?
Make sure you have proper documentation; this is especially true for charitable deductions. Far too many people fail to file Form 8283 when claiming noncash charity contributions over $500. Maybe you do earn $30,000 per year and donated a painting worth $500,000 – but the IRS doubts it.
Do you run a small business, particularly one that is run on a cash basis?
Cash may be king, but the IRS is smart enough to know that sometimes cash falls through the cracks of tax reporting. Be sure you have a systematic way to capture income in your records and that for whatever expenses you claim, you can substantiate.
Do you have gambling winnings that you neglected to report?
It may seem strange, but you should know that casinos file W-2G forms, which state how much and to whom they have paid winnings. What happens in Vegas stays in Vegas – except on the off chance you come home with a heavier wallet; then what happens in Vegas goes in government documentation.
Do you commonly deduct business meals, travel, and entertainment?
This area always seems to be a black hole for a lot of taxpayers. Two questions agents will ask when analyzing your deductions in this area will be related to whether or not it’s a personal or business expense and, regarding food and entertainment specifically, whether or not the correct limitation percentage (currently 50%) has been applied[i].
Have you followed a prescribed estimated tax plan if you are self-employed?
If you are self-employed, or receive some other income where withholdings are not taken out, the IRS requires you to pay estimated taxes throughout the year on a quarterly basis[ii]. Failure to pay your estimated taxes provides yet another reason for agents to snoop around your records and dig a little deeper.
Listen, there’s no such thing as a tax return that has a 0% chance of an audit, even if you use a qualified tax preparer. And this list is certainly not exhaustive, but it should help give an indication of what agents look for. Claim every deduction you are eligible for, be honest, and keep good records.
[i] IRC, 274 (N)
[ii] IRS, Publication 505. Tax Withholding & Estimated Tax