The Top 13 Tax Audit Triggers
Most audits aren't the result of mathematical errors
Studies have shown that sitting down to prepare a tax return can actually raise some people’s blood pressure, and it’s not the unpleasantness of having to crunch numbers that causes the spike. It’s fear of making a mistake that could incur the wrath of the Internal Revenue Service (IRS) and plunge the tax filer into the nightmare of an audit.
But full-blown audits don't actually happen all that often. The IRS is auditing fewer returns these days, mostly due to federal budget cuts that have affected staff size. Only 1.06 million returns earned extra, intense review in 2017. That might sound like a lot, but that's down from 1.74 million in 2010.
That said, taxpayers commonly make a few mistakes that can increase their chances of falling victim to an audit.
The Computer Trigger
The IRS has a computer system that's specifically designed to detect anomalies in tax returns. It’s called Discriminant Information Function (DIF), and it scans every tax return that the IRS receives.
DIF looks for things like duplicate information—maybe two or more people claimed the same dependent—as well as deductions and credits that just don’t make sense. The computer compares each return to those of other taxpayers who earned approximately the same income.
Most people who earn $40,000 a year don’t give $30,000 of that money to charity, for example, so DIF is pretty much guaranteed to throw a flag if you claim that you did. DIF's flag prompts a review by human agents.
You Earn a Lot…Or Very Little
The IRS isn't going to waste time its time on an audit unless agents are reasonably sure that the taxpayer owes additional taxes and there’s a good chance that the IRS can collect that money. This approach puts a focus on high-income earners.
The majority of audited returns are for taxpayers who earn $200,000 a year or more, and most of them had incomes of over $1 million. If nothing else, all that income results in some pretty complex tax returns, and complex tax returns are more likely to include errors.
Conversely, you stand a higher chance of being audited if you manage to wipe out most of your income through the use of tax deductions. Only about 1 percent of taxpayers earning between $200,000 and $499,999 were audited in 2016, whereas 3.25 percent of those who reported no adjusted gross income found themselves under the IRS microscope.
According to IRS statistics, you’re safest if you report income in the neighborhood of $50,000 to $74,999. These taxpayers are audited the least.
You Overlooked Income
Tax laws abound requiring individuals and companies to report remittances both to the IRS and to the taxpayers who received the income. Your employer must issue a W-2 for your earnings and submit a copy to the IRS as well, and independent contractors and freelancers receive Forms 1099-MISC, typically when they’re paid more than $600 for services.
The IRS gets copies. If you have interest or dividend income, you can expect a Form 1099-INT or 1099-DIV at the end of the year—and, yes, the IRS gets a copy of these, too. You can even expect that you and the IRS will receive a Form W-2G if you win big at the casino or hit the lottery.
DIF knows all about these information forms that the IRS receives, so up goes the flag if your tax return fails to include any of them. Keep careful track of all income you receive and be sure to report it. And you might want to keep track of income that does not result in an information return, too, such as tips, cash you were paid for services, or income that falls under that $600 1099-MISC limit.
With very few exceptions, all income you receive is taxable and must be reported. Alimony is an exception as of 2019, thanks to the Tax Cuts and Jobs Act (TCJA). Spouses receiving alimony no longer have to report it and pay taxes on that income.
You Spent or Deposited a Lot of Cash
Various types of businesses are required to notify the IRS whenever anyone engages in large cash transactions, typically involving $10,000 or more. If you plunk down a lot of cash for any reason, you can expect the IRS to wonder where that money came from, particularly if your reported income doesn’t support it.
Maybe your teenager has been saving for years to buy his first car. He empties out his savings account and hands over $10,000 to purchase his new wheels. The IRS will be notified if he buys from a dealership rather than a private party. He should be prepared to show the IRS how he accumulated that money if he files a tax return. He might hear from the IRS even if he doesn't have to file a return; if his income is that minimal, it really waves a red flag.
Reporting rules for banking and financial institutions impose time limits as well. A $9,999 deposit on Monday might not have to be reported, unless you deposit an additional $1 on Tuesday.
You Claimed a Lot of Itemized Deductions
The IRS expects that taxpayers live within their means. They earn, they pay their bills, and maybe they’re lucky enough to save and invest a little money as well. If these amounts don't seem reasonable or you're claiming tax deductions for a significant portion of your income, it can trigger an audit.
This trigger typically comes into play when taxpayers itemize. Mother Teresa might have been able to get away with giving 75 percent of her income to charity, but it’s just not a realistic scenario for most individuals. Likewise, if you claim that you spent a great deal on mortgage interest when you just don’t earn enough based on your reported income to qualify for such a large mortgage, that scenario will raise questions.
If you earn between $50,000 and $100,000 a year, the IRS figures that you probably won’t make charitable contributions in excess of about $3,100 or pay mortgage interest in excess of about $7,500 a year. And if you do give away anything valued at more than $500, don't neglect to get the item appraised and submit Form 8283 with your tax return.
You Dipped Into Your Retirement Funds
Maybe you’re not quite near retirement age yet but something has happened that requires you to dip into the money you’ve been investing in a 401(k) or IRA. This, too, can trigger an audit—not because it’s considered tax fraud to take early withdrawals, but because many people who do so also make mistakes on their tax returns.
The IRS reports that a walloping 40 percent of those taking early withdrawals also goof when they report the event on their tax returns. And when mistakes occur, that's likely to result in additional tax revenue for the IRS.
Most of these mistakes relate to taxpayers not paying the corresponding tax penalty for early withdrawals. The magic number is age 59 1/2. If you’re older than this, withdrawals are typically no big deal, although in many cases you'll have to pay income tax on the distributions.
If you’re younger, however, you’ll also have to pay a 10 percent tax penalty on the withdrawal. There are exceptions to this penalty, but don’t claim one of them unless you’re very sure you qualify. The IRS says that this is where most people make mistakes and open themselves up to an audit.
Sole proprietors and freelancers are entitled to a host of tax deductions that most other taxpayers don’t get to share, such as home office deductions, mileage deductions, and deductions for meals, travel, and entertainment. These expenses are tallied up on Schedule C and deducted from your revenues to determine your taxable income from your business.
DIF is on the lookout for deductions that are above the norm for various professions. It might be expected that you would spend 15 percent or so of your income on travel each year if you're an art dealer because that's about what other art dealers spend. If you claim 30 percent, you can probably expect the IRS to take a closer look at your return.
Have you noticed those occupational codes that appear on your tax return? The IRS uses those to make sure that your travel expenditures are in line with others who report those same codes. You'll most likely get a second look from the IRS if you've claimed 20 percent more than the average for your profession.
Likewise, if you use your car for business purposes and you want to deduct your expenses or mileage, the IRS doesn’t want to hear that 100 percent of your travel was solely for business purposes, especially if you have no other vehicle available for personal use. Presumably, you drove to do personal errands at some point.
Your Business Is Home-Based
The IRS knows that taxpayers who claim home office deductions often get the rules wrong, so there are potentially some additional tax dollars to be had here as well.
The ironclad rule is that you must use your home office area for business, and only business. You—and your family members—literally cannot do anything else in that space. Review IRS Publication 587 if you're planning to claim a deduction for a home office. You'll really want to get this one right.
You Own a Cash Business
If you operate a mostly cash business—no one is issuing you 1099s for your services but rather they’re handing over $50 for that haircut—this can put you on the IRS radar as well.
Businesses that fall into this category include salons, restaurants, bars, car washes, and taxi services, according to the IRS. Perhaps unfairly, the government takes the position that it's particularly easy for the owners of cash businesses to stuff that $50 into their pockets and forget about it at tax time. A flag will go up if your lifestyle is such that your reported income just can't pay all your bills.
How would the IRS know about your lifestyle? The IRS takes tips from concerned citizens. So if you've made a few enemies and you're driving around in a Ferrari while you're reporting income of $50,000, the IRS might find out about it.
You Claim Your Hobby as a Business
Maybe you breed puppies and sell them. Does this mean you’re self-employed? Possibly, but a whole lot of tax rules determine the distinction between a business and a hobby.
If you're self-employed, you get all those neat Schedule C tax deductions. You're pretty much out of luck if your enterprise is a hobby. It used to be that you could deduct expenses up to the amount of income you received from your endeavor if you itemized, but the TCJA has affected this deduction too, repealing it.
Your hobby is not a business if you haven’t shown a net profit from it in at least three of the last five tax years. An exception exists if you’re breeding horses—in this case, it’s two out of seven years. If you're just starting out and this is your first year at your enterprise, you can file Form 5213 to give yourself four more years to generate that profit, but this can trigger a closer look by the IRS, too.
The IRS probably won’t consider your enterprise a business if you don’t depend on the income to make ends meet or devote the necessary time, effort, and money to maximizing your profits. In other words, you really work at it and for a significant amount of time each day. You'll need records to prove that if you're audited.
You Have Assets or Cash in Another Country
This is a big one. The IRS is particularly interested in taxpayers who have assets and cash stashed in other countries, particularly in nations with more favorable tax laws than in the U.S. In recent years, the IRS has ramped up its rules for overseas assets as well as its scrutiny of such tax returns.
The IRS can usually access your account information from a foreign bank, and it will do so if it feels that you might owe taxes on the money you've placed there. In fact, some foreign banks are obligated to provide the IRS with lists of American account holders.
You’re obligated to report all foreign accounts with total cumulative balances of more than $10,000 on FinCEN Form 114. Foreign assets valued at $50,000 or more must be reported on IRS Form 8938. You'll comply with tax law if you do so, but you might also expect the IRS to check and make sure that your account balances really are what you’ve claimed them to be.
You Have Investment Income
Remember, the IRS receives copies of all information returns bearing your Social Security number. It can be all too easy to overlook or misunderstand some of them, particularly when you have investments. Keep an eye out for those 1099 forms that will be arriving after the first of the year. The IRS will be.
If the IRS receives a 1099 showing that you were paid interest or dividends and if that interest or those dividends aren't reported on your tax return, you'll receive a letter from Washington inquiring about it. But the letter shouldn't lead to a full-blown audit if you simply agree to the income adjustment.
You Claimed the Earned Income Tax Credit (EITC)
Claiming the Earned Income Tax Credit is something of an automatic audit trigger, but you probably won't even know that the IRS is reviewing your return.
The EITC is a refundable tax credit that increases with the number of child dependents you have. If you're eligible to claim it and the amount is more than any tax you owe, the IRS sends you a check for the difference. But the government doesn't want the IRS to do that before making absolutely sure that you really are entitled to claim those dependents and that the income you're reporting is accurate, because there are income limits for qualifying as well.
The Protecting Americans from Tax Hikes (PATH) Act therefore requires that the IRS can't issue refunds for any tax returns claiming this credit until mid-February. This gives the agency time to review these returns and make sure everything is on the up-and-up.