Empyrion Wealth Management

Most of us have heard the news that audit rates are falling at the IRS. Due to continued staffing shortfalls at the service, the average taxpayer is much less likely to experience an audit than in times past. In fact, the number of returns audited by the IRS has fallen from 1.74 million in 2010 to just slightly over a million in 2017.

That’s the good news. But the less good news is that there are still red flags that can cause your return to receive greater scrutiny by the IRS. Naturally, you should do everything possible to avoid drawing attention to yourself at tax time.

1. Misreporting or failing to report income. This one is pretty basic. If the income from all your W2s and 1099s doesn’t match the income on your return, your information is going to get a closer look. At the very least, you will probably get a bill for tax on the unreported income. At worst, you will get a notice of your upcoming appointment with an auditor.
2. Earning in excess of $200,000 per year. If you make less than $200,000 in income, your chance of being audited in 2017 was only slightly greater than 0 out of 100. But if you made more than $200,000, your chance was four times greater. And if you make $1 million a year or more, you had twenty times the risk of an audit. Remember when the police asked the bank robber why he robbed banks? He said, “Because that’s where they keep the money.” The IRS follows the money; the more of it you make, the higher your chance of having your return flagged for audit.
3. Drastic changes in income. Whether you experience a huge increase or a big drop, major shifts in your income level tend to catch the eye of IRS examiners. This can also be an issue for self-employed individuals when business expenses ramp sharply up or down from one year to the next. Sometimes this accurately represents the facts of your situation; just make sure you’ve got the receipts and other documentation to prove it.
4. Unusually large charitable donations. The IRS is phasing in stricter rules for documentation of charitable giving. They are also focusing closely on claimed deductions that are out of line with averages for the taxpayer’s income bracket. Additionally, the new Tax Cuts and Jobs Act has dramatically raised the standard deduction, making it even less likely that most taxpayers will have sufficient charitable and other deductions to add up to more than their standard deduction. It’s fine to be unusually generous; just make sure you have your records in order.
5. Incorrect Social Security numbers. With all the current concern over identity theft, any return that has discrepancies between the number on the return and the number on any source documents will almost invariably attract extra scrutiny.
6. Money lost to hobbies. IRS guidelines about what constitutes a legitimate business and what is merely a hobby are very strict. Large losses attributed to activities like horse racing and animal breeding will typically attract attention, especially if you cannot demonstrate that these are a principal form of employment.
7. Alimony reporting. Ex-spouses who receive and deduct alimony must provide the Social Security number of the ex-spouse who is paying it. It is easy for the IRS to match the two amounts, so accuracy is paramount. Another result of the Tax Cuts and Jobs Act, by the way, is that alimony for divorce settlements after December 31, 2018, will no longer be deductible.
8. Improper home office deductions. Unless you have a specific room in your home where you work, don’t try to claim the home office deduction. Working from your laptop and cell phone on the living room couch doesn’t qualify as having a home office. If you intend to claim this, make sure you follow the IRS guidelines.
9. Unusually large meal and entertainment expenses. Based on the millions of tax returns they process for individuals and businesses, the IRS has a fairly accurate idea of what constitutes typical business entertainment and meal expenses for a given situation. If your claim is very far above that line, your return is likely to get a closer look from the IRS. And the new tax law contains stricter limits on deductibility of such expenses.
10. Cash businesses. Convenience stores, restaurants, bars, and other similar businesses that typically take in lots of cash payments have many more opportunities than others to hide or under-report income. The IRS knows this, and they look at the returns accordingly.

As you can see, some of these red flags are not automatically indicative of wrongdoing; they’re just a consequence of the type of business or activity in which you are engaged or your income level. Nevertheless, forewarned is forearmed. If any of these apply to you, take extra care with your return and your documentation. After all, your tax return is one place you really don’t want to stand out from the crowd.

Stay Diversified, Stay YOUR Course!