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Potential Red Flags for IRS Audit

By: Tax Hotline
Fall 2022 (Vol. 40, No. 3)

With taxes becoming more complicated every year, there is always the possibility that a tax mistake turns into an IRS tax audit. Avoiding “red flags” like the ones listed below could help. That doesn’t mean you should not take legitimate expenses or overstate income. You don’t have to completely avoid these tax moves, just take extra care to document it well enough to prove your claims.

Failing to report all income. Under reporting is a top reason for an audit. Keep in mind, when you get a 1099 or an investment distribution form, the IRS receives the same form. If the IRS finds a mismatch, you will hear about it.

Not filing at all. If you are required to file a return and you just refuse to comply, the IRS will catch up with you.

Sloppy reporting. Proof your return for errors. Listing incorrect social security numbers, wrong names, incomplete or missing information, math errors or filing the wrong schedules may trigger the IRS to take a closer look.

Claiming business losses every year. When you operate a business and file Schedule C, the IRS assumes you operate that business to make a profit. The IRS defines a business as the “intent to make a profit. It’s common for a new business and even long-term businesses to operate at a loss for a year or two but in theory, most businesses should show profitable years as well.

Obvious guesses. If your expenses all end in neat even numbers, it may look like you are guessing at numbers. It’s OK if each expense category comes out with the same last digits, but just be sure to have the receipts.

Unreasonable incomes. If you are a CEO living at an expensive address, it may seem suspicious if you claim an income far below what your expenses should be.

Expenses that don’t make sense. For example, a local junk hauling business typically wouldn’t have high travel expenses.

Excessive business expense deductions. Too many deductions for your income and type of business, claiming 100 percent use of a car for business, and inflating business meals, travel, and entertainment expenses are examples of excessive business expenses that could raise a red flag. Always save receipts and document your mileage and expenses.

Exceeding occupational norms. The IRS uses a formula to measure typical amounts for expenses such as travel by profession.

Claiming 100% use of a vehicle. If you have no other vehicle for personal use, the IRS may question a claim that you never use the business vehicle for personal use.

Taking an early withdrawal from a Retirement Account. It’s OK to take a withdrawal, but just make sure you report it accurately. This is an area where the IRS saw a lot of errors sin the past o now it can trigger a closer look.

Failing to report winnings or claiming big gambling losses. Professional gamblers report winnings/losses on Schedule C, Profit or Loss from Business (Sole Proprietorship). They can also deduct costs related to their professions, such as lodging and meals. Gambling winnings are reported on Form W-2G, which is sent to the IRS. As such, you must report this income. You may deduct gambling losses, but you must itemize your deductions on Schedule A (Form 1040) and keep a record of your winnings and losses. Ordinary taxpayers (recreational gamblers) report income/losses as “Other Income” on Schedule 1 of their Form 1040 tax return.

Unreimbursed employee expenses. If it costs you more than 5% of your earnings to do your job, make sure you can prove it was required and you have receipts.

Claiming Real Estate Professional. To qualify for this classification, you would need to prove you spent 50% of your work hours related to real estate, perform more than 750 hours of service in real property trades or businesses and own at least a 5% stake in each of the properties you are claiming the professional status for. If you are claiming this status, it is important to keep meticulous records. For example, if you have a 40 hour a week job in another sector, the IRS may question how you spent more than half your working hours selling or managing your real estate.