10 Red Flags that Could Trigger an IRS Audit

Did you file your taxes? Do you know what your chances are of getting audited?

The probability of getting audited by the Internal Revenue Service (IRS) is relatively slim. The number of tax returns audited in 2019 was 0.4%, down from 0.59% in 2018 and 1.10% in 2010.

However, there are red flags that could generate an audit or at least a closer review of your tax return. The number of returns audited goes up with income over one million dollars. The safest income level from audits is $25,000 to $200,000.

Many audits or reviews occur without the taxpayer being aware. The IRS has DIF computer system. It is designed to compare information. Were all W-2’s and 1099’s reported? Are multiple taxpayers claiming the same dependents? Do the deductions and credits relate to the income level? Results from the system review may prompt a view of the return by auditors.

Some activity that may generate more scrutiny are:

Running a Business

Running a business with Schedule C saw 1.6% audit activity in 2019. The more the gross receipts, over $100,000, the higher exposure to an audit. Cash intensive businesses like taxis, salons, convenience stores, car washes and laundromats will be reviewed comparing to industry standards.

Hobby Losses are on Schedule C

A taxpayer needs to operate the business as any prudent business person would. The business needs to make a profit 3 of 5 years. Recent tax law changes disallowed taking expenses up to your income level.

Business Use of a Vehicle

Claiming 100% use for the business is likely to get scrutiny. IRS is targeting SUV’s & large trucks as they have more favorable depreciation deductions. Document your travels with a mileage log.

Home Office Deduction

This is for business owners only. The home office must be exclusively for business. This deduction is not for employees – even if they worked from home during the pandemic.

Premium Tax Credit for Health Insurance

IRS is prowling for people who receive advance subsidies and don’t file a tax return or they file a return and report the credit wrong. IRS is also looking for taxpayers whose Adjusted Gross Income (AGI) is above the limit for the Premium Tax Credit. Taxpayers must attach IRS Form 8962 for this credit.

Virtual Currency Transactions

IRS has set up teams of agents to work on crypto currency. They are on the hunt for taxpayers involved in any form with bitcoin or virtual currency. The agency went to Federal Court to get names of customers of Coinbase. The 2020 tax return for Individual filers had a question regarding the taxpayer involvement with virtual currency. IRS believes there is unreported income

American Opportunity Tax Credit

College is expensive. Tax credits can offset some of that expense. IRS is looking for taxpayers that take the credit for more than 4 years for the same student. Or the taxpayer omits the school’s taxpayer ID on Form 8863. Or using the credit without getting a 1098-T. IRS is also looking for taxpayers claiming multiple tax breaks for the same college expense.

Big Change in Income or Expenses

A big change in income may occur in exercising company stock options. Large capital gains are self-explanatory. Yet 1031 exchanges may get reviewed to be sure reporting is done correctly.

Early Payout from Retirement Plans

1009-R‘s are issued for payments that come from 401(k), IRA, and 403(b) retirement plans. If you are under 59½, the distribution is not only income but maybe subject to a 10% early distribution penalty. There are a few exceptions from this 10% penalty.

  • Qualified first-time home buyers up to $10,000
  • Medical expenses that are unreimbursed and over 10% of AGI
  • Health insurance premiums paid while unemployed
  • Qualified higher education expenses
  • Total and permanent disability of the participant/IRA owner
  • To an alternate payee under a Qualified Domestic Relations Order

The 1099-R won’t report these exceptions. Taxpayer would report them on Form 5329. Be sure your tax preparer knows why you took a distribution.

Earned Income Credit

Claiming this credit on your tax return will automatically be reviewed. This credit is abused. IRS has a requirement that all returns claiming an earned income credit be reviewed before refunding any credit.

You can survive any audit from these or other red flags by keeping good documentation. Tax returns can be audited up to three (3) years and sometimes 6 years after they were filed. Your best defense is good documentation.

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