Do you cringe every time you receive correspondence from the IRS, in fear the letter contains news you have been chosen for an audit? If so, you are not alone. These fears, however, are largely unfounded. Only a small portion of US taxpayers are audited each year and most of those are chosen because of specific characteristics or red flags on their returns.
In 2020, the IRS audited 0.2% of all returns, although the number was down due to office closures and the COVID-19 pandemic. In 2019, a more normal year, the IRS chose 0.4% of taxpayers for audit.
How Does the IRS Choose Who to Audit?
The IRS has two methods for choosing taxpayers for audit. These are:
- Random – as part of its National Research Program, the IRS randomly selects thousands of returns each year for examination. The agency founded the program in 2017 in an effort to track filing compliance overall.
- Computerized screening techniques – through this process, the IRS compares returns against national norms. These are commonly referred to as red flags because returns outside the norm are often flagged for audit.
What Are Common IRS Red Flags?
The IRS has many red flags for identifying taxpayers for audit. These items represent areas where the IRS has found individuals to be less compliant. If you include one of these items on your return, be sure you report accurate figures and have sufficient backup to justify your reporting.
Common red flags in tax audits include, but are not limited to:
- High income – the more income you report, the greater your chance of being audited. In 2020, the IRS audited 1% of returns where taxpayers reported income between $5 million and $10 million, and 5.3% of returns with $10 million or more in income.
- Underreported income – the IRS also receives copies of your 1099s and W2s. The agency will compare income from your return to figures it calculates using these forms. If you have failed to report something, the IRS might flag your return for audit.
- Unreported foreign income – foreign investments have traditionally been a way for wealthy taxpayers to hide assets and income. Because of this, the IRS pays particularly close attention that all foreign income is correctly reported and taxpayers use the appropriate forms to report foreign assets. Taxpayers must report to the IRS all foreign accounts when their aggregate balance exceeds $10,000.
- Home-office deduction – the rules around home office deductions are complicated and detailed. To claim a deduction, you must be self-employed and use the specified area exclusively for your business.
- Business use of automobile – small business owners can deduct business use of a vehicle. To do so, they must keep scrupulous records of business versus personal use. The IRS knows it can be difficult to keep up with this and will often scrutinize returns that report business use of an auto.
- Filing Schedule C for sole proprietors – the IRS keeps norms by profession or business type of typical Schedule C expenses, such as home office, auto, and travel and meals. If your Schedule C expenses fall outside the norm for their category and your profession, it’s likely your return will be audited.
- Cryptocurrency – this currency is on the IRS’s “dirty dozen” list of tax scams. Beginning with 2019 returns, taxpayers were asked to note on their 1040 if they held or engaged in cryptocurrency transactions. The IRS is looking for underreported income.
- Business losses – if you consistently report business losses, the IRS may examine your return to determine if you are truly running a business or trying to claim your hobby as a business. Your return is most likely to be flagged if your business has not shown a profit in three of the last five years.
- Cash-based business – operating a primarily cash-run business, such as a hair salon or restaurant, is an instant flag for the IRS because of the potential for underreporting income.
- Lots of charitable contributions – the IRS looks for charitable contributions that are disproportionately large for your income level.
Have Questions? Call the Experienced Tax Attorneys at Wiggam & Geer
If you’ve been selected for an IRS audit, we can help. The experienced attorneys at Wiggam & Geer can evaluate your situation, recommend a course of action, and represent you during the audit process. Contact metro Atlanta’s top tax attorneys by clicking here or giving us a call at (404) 233-9800.