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Tax Audit 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 [3]. 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 [4]. 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 [5], 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 [6] 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 [7])