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Tax Audit Red Flags

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Red Flags!Last month I had the pleasure of talking to Rich Preece, Director of Product Management for TurboTax, about the improvements they’ve made to this year’s version of the tax preparation software. One area that they’ve improved is in their Audit Risk Results section, which identifies parts of your return that might trigger an audit. They reviewed the audited returns and collected the top twenty five to thirty reasons they believed triggered an audit. Then they look at your return, see if there are similarities, and bring them to your attention. It’s a feature from year’s past but it was the first time I really paid much attention to it. The purpose of the Audit Risk section isn’t to dissuade you from taking deductions that are rightfully yours, it’s designed to remind you to take a microscope to that section to make sure you did everything correctly.

For example, a common audit trigger is the child and dependent care credit. To claim the credit, you need to provide the social security number of the child or dependent. It’s not uncommon for a divorced couple to both claim a child if they are filing separately. What ends up happening is that when the first tax return is processed, the social security number is claimed. When the second tax return is processed, an audit flag is triggered because the child’s social security number was claimed in another tax return. So the purpose of these features, and of the following list of tax audit red flags, is to identify areas you need to take a closer look. Don’t let the fear of an audit stop you from claiming what is rightfully yours, but be careful.

First, review how the IRS picks which tax returns to audit. Some you can avoid, like math mistakes, if you’re preparing your return by hand, and mismatch in the reporting of income, interest, or dividends. Those will usually trigger a CP2000 clarification letter, rather than a full blown audit.

Here are the top tax audit red flags that you may or may not be able to control. The key is to review this list and prepare your return carefully if it involves one or more of these items.

  1. Large changes in income: If you have large swings in your income that aren’t explained with W-2′s or 1099′s, be prepared to explain them.
  2. Claiming a loss on a small business: Anytime you claim a loss, the IRS is going to take a closer look. If you are audited you will need to show that your business is legitimate (prove it’s a business and not a hobby) and detailed records proving the loss.
  3. Claiming large charitable contributions: If you are too generous, it’s a red flag for the IRS.
  4. Claiming a home-office deduction: The IRS knows this is rife with abuse and is on the lookout for people claiming a home office and a salary, or a high home office deduction relative to the business.
  5. Claiming large business meal & entertainment, auto use deductions: This falls under the same category as the home office deduction.
  6. Claiming large casualty losses: If you suffered a significant casualty loss and are claiming it on your taxes, be sure to read up on Casualty, Disaster, and Theft losses as the rules are very specific.
  7. Claiming rental losses: Like casualty losses, this is another complicated section of the tax code where lots of people slip up. If you otherwise work and are renting out a former residence, you are considered passive and can only deduct a limited amount of your losses ($25,000). Claim more than that and the IRS will want you to prove you were a material participant.

Remember, even if you stay clear of all these, and other, audit red flags, you could still be randomly selected for an audit! So don’t let the fear of an audit prevent you from claiming a deduction that is rightfully yours.

(Photo: rvw)

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18 Responses to “Tax Audit Red Flags”

  1. zapeta says:

    Thanks for the list. My return is not very complicated so I have none of these red flags but as you said, if you’re owed the deduction and are audited you’ll be fine as long as you can show you earned it.

  2. Wilma says:

    Cover thy butt with documentation and if your audited you’ll skate through. I got audited once and they couldn’t believe I had everything organized and ready. I passed. =)

  3. ebow says:

    Good list, but readers shouldn’t get too paranoid just because they fall under a few of the situations described. My wife and I had a return this year with a small business loss, home office deductions, and deductions for business auto use, travel, etc. (though probably relatively small deductions). TurboTax told us our audit risk was high (probably 90% of the way up their bar) but our return was accepted within hours of submitting it. (I assume it being accepted means the IRS won’t be auditing this year–I know they can go back and audit previous years… and if I’m wrong, at least we have the paperwork to back up the deductions.)

    • NCTaxPro says:

      ebow:

      You cannot assume that IRS acceptance = no audit. IRS rejects E-filed returns only under specific circumstances, for example, if you try to claim a dependent that has already been claimed by someone else, or when a name entered on the return doesn’t match the name associated with the SS# (common when a couple has married recently and the spouse doesn’t register his/her name change with SSA).

      That said, if you do have documentation you have little to fear from an audit.

  4. Great list to know, especially the ones about small businesses. Many times a small business tries to save a few more bucks by making those extra deductions, but it may end up causing them more trouble in the end. I have heard from many people with the home office deduction and how you have to be really careful with that.

  5. Good info to know. I have to admit-this is the first year I am filing as an LLC for my blog/consulting, so all frugal tendencies aside I decided to have a professional prepare them this year. I didn’t want to miss out on any legit deductions etc, but I also didn’t want to do anything wrong by accident and get audited :)

    • NCTaxPro says:

      Jenn:

      Good idea. I think it’s more frugal to consult a professional when you are not sure of what to do than it is to muddle through yourself and open the door to penalties and interest!

      That said, remember that if you are into blogging-as-a-business (and I know you mentioned that you are consulting as well), you need to make sure that you actually have a business purpose that you can document if the IRS comes calling – especially if you are showing losses. The potential exists for the IRS to look at your blogging “business” as a hobby instead, especially if you show losses. Generally they won’t do that for several years, but the explosion of blogging-as-a-business models lately is likely to catch the agency’s attention sooner rather than later.

      • Well, I did go through the process of legally becoming an LLC. . . “Upstate Media” which includes blogging, freelance writing & consulting. Does that cover me as far as a business purpose goes?

        • Jim says:

          What he means is proof that you’re operating it as a business with a profit motive, which forming an LLC does take a step towards. I would also open up a business bank account, preferably one without fees, and you should be OK. If you’re showing losses, I’d consult a professional as to what else you can do to prove motive but you’ll be fine if you book a profit.

          • Great, thanks. I do have an account that is opened in the LLC name and is only used for those expenses, as well as a credit card.

            I think my net profit this year was $428. . . but that’s because I spent as much attending conferences as I made :)

  6. Ginny says:

    If the IRS has enough staff to audit one out of every 107 returns, then they have too much staff.

  7. jsbrendog says:

    this is all good stuff to know. bookmarked.

  8. Anthony says:

    I’m sorry, but I’m tired of the FUD being spread about the home-office deduction. It’s like any other deduction – it can be used and it can be abused. If your business can legitimately claim the deduction and has documentation to back it up, then by all means claim it.

    The IRS is like any other organization, some employees are jerks, but most are reasonable people like you or I that are trying to make a living. In the face of decent documentation, I’m sure an auditor will thank you for your time and complete their report. Heck, they might even find a mistake in your calculations in your favor and issue a check for the difference!

    • NCTaxPro says:

      Anthony:

      The key word is “legimately”.

      The home office space must be used regularly and exclusively for business – and exclusively means just that. You may conduct business from your home office, but if you use it for any non-business purpose you can’t claim it.

  9. Henry Patman says:

    I have on occasion reported more than the actual profit on my very small home business… just to avoid setting off any alarms. I’ve been audited, and it’s no fun even when you’re covered.

  10. eric says:

    Good info and thank god the stuff doesn’t concern me much right now. Let’s hope I don’t have to deal with audits any time soon (or ever)!

  11. Awesome Post!

    I am so glad that we are presenting a balanced perspective to the public regarding IRS audits.

    Thank You Jim!


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