On average, the IRS audits about 0.6% of tax returns each year. This means that your chances of being audited are relatively low.
However, IRS audits are seldom random. Though a sample of taxpayers’ returns is selected at random for an audit each year, the bulk of tax returns that get audited were flagged because of some sort of “suspicious activity.”
In this article, we’ll shed some light on what triggers a tax audit and how you can potentially avoid one.
Computer-Generated Red Flags
Last year the IRS received more than 240 million tax returns. Given that the IRS has been around since 1859, they’ve had almost 200 years of data to compile. Using this data, they know what normal averages are for countless situations, ranging from tips as a bartender to how much it costs to run a home office. If the IRS notices that your income or deductions are far outside of an expected range, it’s likely that your return will require a second look.
Now, with computers and complex data mining and AI, it’s easier than ever for the IRS to identify an abnormal return. The actual system is referred to as Discriminant Information Function or DIF for short. Using this system, the IRS can quickly identify a return that doesn’t fit within normal expectations.
For example, if your deductions are higher than your income, or you claim that you donated the bulk of your income to charity even though you’re not wealthy, the IRS will assume something fishy is going on.
The best tip here is triple check your math and be reasonable with what you deduct or claim. Honesty is the best policy.
You Earn a Lot or a Little Income
In general, it’s not worth the IRS’s time to go after small potatoes. Instead, they target high earners with income in the high six and seven figures. That being said, they may also be interested in a return that shows very little earnings, especially if there was significant gross income.
You Don’t Claim Documented Income
Income received from employers, clients, investments, gambling, etc., is usually documented via various forms such as W-2s, W-9s, 1099s, and W-2G forms.
The IRS receives copies of these forms and can cross-reference them against your returns. If there’s a discrepancy, you could easily be audited.
You Make Large Cash Deposits
If you’re being paid under the table or get cash from tips, you may end up depositing your paper currency into a bank account.
The IRS gets notified of any deposits over $10,000, and they could also be flagged if you make a series of large deposits. This can happen even if they’re under the classic 10k threshold.
Your Deductions are Unreasonable
There’s nothing wrong with claiming every deduction under the sun, as long as it applies to your financial situation.
The government rewards the activities that they want taxpayers to do by offering tax incentives and deductions. Still, it can be tempting to go overboard and look for deductions that aren’t appropriate. Just as bad in the eyes of the IRS is inflating the amount of a deduction to avoid tax responsibility.
There are various forms you can submit with your return if a legitimate deduction could be viewed as suspicious. For example, Form 8283 can be filed for physical goods donations to charitable organizations valued at over $500.
You Are Self-Employed or Run a Home-Based Business
There are complicated rules for self-employment and home business deductions, and these rules change routinely.
Before filing a return, make sure you know what the rules are and resist the urge to claim deductions that aren’t allowable. The classic example is deducting the square footage of a dining room table as an office space expense when, in fact, the table is used for purposes other than just your business.
The IRS website has a wealth of information about what you can and can’t deduct when you use your home for business purposes, including this page, updated in 2020.
Your Business Collects A Lot of Cash
It’s not uncommon for service-based businesses such as restaurants and salons to deal in cash. In fact, any company that accepts cash can be suspicious to the IRS. The reason is that it’s pretty easy to pocket the cash and not report it as income since there’s no paper trail.
The IRS has a handful of businesses that are high on their radar, and if you fall into one of these categories, know that you could be at a higher risk for an audit:
– Car washes
– Bars and restaurants
– Taxi services (have you noticed that cab drivers often ask for cash?)
– Strip clubs
Having a cash-rich business alone isn’t usually enough to trigger an audit, but if your lifestyle is far more lavish than the income you report, the IRS could do some digging into your finances.
The Bottom Line
Though the chances of a tax audit are relatively low, there are actions, both intentional and unintentional, that you can take that can increase your chances of being flagged. With some careful planning, you can minimize that risk. Contact us for a free tax analysis to discuss your situation with our team of accountants, attorneys, and former IRS officers.