Clients often ask many questions, but one of the most frequent of them is, “will taking a deduction for (fill in the blank) flag my return for an audit?” Of course, the answer is often a qualified “yes”. Yes, some taxpayers are at higher risk for audit, because of their reported deductions, but that doesn’t mean they should forego those deductions. In the next few paragraphs, we will discuss what types of transactions can raise the IRS’s eyebrows and why you shouldn’t shy away from them.
What color is your flag?
What red flags does the IRS look for in choosing a tax return for audit? While some may feel the IRS sees their name and automatically chooses their return, for the most part, that’s just unfounded paranoia. The IRS has developed certain criteria that it feels increase its chances of catching erroneous returns.
One tool in the IRS arsenal is the DIF score. Basically, the IRS computers look for returns that are outside the norm. They will compare your deductions to the returns of others in your same income bracket. If the deductions are outside the expected range, your chances for an audit will be increased.
Is your calculator working? Let’s hope so, because the IRS computers have very good calculators - and mathematical errors are another red flag to the IRS. This will almost guarantee receipt of a letter from the IRS, which is included as an audit in their statistics, but is unlikely to cause a full audit. Make sure there are no math errors in your return before filing it. Remember, the only letter you want to get from the IRS this year is the one with your tax rebate check.
Another way to guarantee that you get a letter from the IRS is failure to include income amounts reported to the IRS by third parties. For example, dividend and interest, partnership income, proceeds from the sale of real estate, proceeds from the sale of securities and many other items are required to be reported to the IRS by someone other than you. The IRS then checks your return to see if you have reported the income. If not, you will receive a tax notice from the IRS.
Taxpayers in businesses that take in a high proportion of their income in cash also are at higher risk for audit.
How well did you check out the reputation of your preparer? While it’s hard to tell sometimes, there are unscrupulous tax preparers, and the IRS knows it. If your preparer guarantees you will get a refund or seems to be taking deductions that are unreasonable, you may want to get a second opinion on your return before the IRS offers its own advice in the form of a higher tax bill, with penalties and interest.
Taxpayers whose adjusted gross income is over $100,000 will receive special attention from the IRS, which in turn increases the chance that a return will be flagged for audit. Individuals with earnings that are offset by large farm or partnership losses also have a higher audit risk. Taking a deduction for using an office in your home is yet another red flag for the IRS
Dealing With Your Red Flags
Flags are meant to be flown, whether red or red, white and blue and so it should be with yours. Assuming your deductions are legal and appropriately substantiated, you should never fail to make use of them to minimize your tax liability for several very good reasons.
First, it’s your legal duty to observe all tax laws. If you fail to take a legitimate deduction, you are, in essence, violating the tax code. Is that a criminal offense or even one that you will ever be called on? No, but that doesn’t mean you shouldn’t obey the law.
Second, you have no moral requirement to pay a penny more in income tax than you legally owe. If you are reading this article, chances are you have already paid a fair amount of your income to the government in the form of taxes. Do not let fear of the IRS cause you to pay more.
Third, even if you are audited, if you have prepared your return properly, you don’t have anything to fear. Too often, a client will not take a legitimate deduction for fear of being audited. As long as you can document/substantiate the items in your income tax return, an audit may cost you some time, but should not result in additional taxes.
Certain transactions and some line items on a tax return can increase your risk of being audited. However, you should never fail to take a legitimate deduction when you can fully substantiate it. If you have questions regarding what deductions are legitimate, need a second opinion on your return, or simply need a new tax advisor - give us a call.