You receive a letter in the mail with the seal of the Internal Revenue Services on the envelope. Immediately, your blood pressure rises, and you feel your mouth turn dry. It turns out your worst nightmare has come true – the IRS is auditing you.
The reality is that the IRS only audits a fraction of people every year. If you get a notification that the IRS is auditing you, you either are a very unlucky taxpayer or you raised a red flag on your last tax return.
In 2017, only 1.06-million of America’s 140.9-million taxpayers received an audit, that’s a figure of less than 0.7%. That number is down from a total of 1.74-million audits in 2010, and federal budget cuts are the cause of fewer audits.
So, what does it take to trigger an IRS audit? What can you do to ensure that you stay out of the 0.7% the IRS decides to scrutinize each year?
You Can’t Beat the Computer
The IRS manages a computer program called the Discriminant Information Function (DIF). The DIF scans every single tax return the IRS receives, looking for anomalies. The DIF scans for things like duplicate information, where more than one person claims the same dependent or deductions that don’t make any sense.
The DIF compares each tax return to other taxpayer’s returns in the same income bracket. For example, most people than earn $50,000 a year, wouldn’t be donating $40,000 of that income to charity.
If the DIF red flags you, then you can expect IRS agents to follow up with you.
You’re a High or Low Income Earner
The IRS focuses its efforts on catching people that are intentionally evading taxes. Most of the culprits lie at either end of the Bell curve, so they’re generally checking for discrepancies with people that earn a high income, and those reporting low incomes.
The vast majority of audited income returns focus on individuals earning more than $200,000 per year. People with large estates and significant incomes have complicated tax returns that are more likely to contain errors.
You also might trigger an audit if you decide to claim too many itemized deductions on your return. However, only 1% of all taxpayers earning between $200,000 and $499,999, received an audit in 2016. However, 3.25% of those reporting no adjusted gross income (AGI) found themselves facing an IRS audit.
According to statistics from the IRS, the safest option is to report an income between $50,000 to $74,999. This income bracket receives the least amount of audits.
You Overlook and Don’t Report Income
All employers and employees must abide by the tax codes request for information. All employers must submit W2 reports for employee’s earnings to both the employee and the IRS. Freelancers and independent contractors receive Form 1099-MISC when they receive payment for services that amount to more than $600.
The IRS gets copies of all of these forms, and if you get any dividend income or interest from assets, then you can expect to receive Form 1099-INT or 1099-DIV to list your earnings at year-end. If you visit a casino and strike it lucky, you can expect to receive Form W-2G.
The DIF hosts all the information regarding returns, any discrepancies, and the system will notify the management of your behavior.
The Tax Cuts and Jobs Act (TCJA), granted an exemption for alimony from income taxes in 2019, so you don’t have to worry about claiming that on your return any more.
You Deposit or Spend a Large Cash Sum
Various businesses have to file forms with the IRS if you deposit or spend more than $10,000 in cash. The anti-money laundering restrictions are common whenever you process large transactions.
When depositing the cash at your bank, or buying gold coins to a value of more than $10,000, the financial services provider reports your payment activity to the IRS. If the IRS does receive a red flag that you spent or deposited more than the $10,000 threshold, you can expect a call from agents looking for you to prove how you got the funds.
You Claim Too Many Itemized Deductions
The IRS expects that most taxpayers live within their means. As a result, most of us earn a living that pays for our bills, leaving us with a bit to save and invest for retirement. If the DIF detects that you’re spending or saving beyond your means, it could trigger an audit.
Another mistake people make is claiming too many itemized deductions on their return. If these amounts don’t add up, then you can also expect it to trigger an audit by the IRS. For example, if you claim a large deduction for mortgage interest, but the value of your home and your earnings don’t match up, it could cause a red flag that leads to an audit.
You Cashed in Your Retirement Funds Before the Maturity Date
Your 401(k) and IRA are there for your retirement years. However, often, there are situations in life that call for you to dip into your retirement account. Whether you lose your job or incur a surprise medical expense, sometimes the only way to fund it is with your retirement money.
However, research from the IRS shows that over 40% of all people who dip into their retirement accounts prematurely fail to include the correct amount on their tax return, triggering an audit. The IRS is aware of these mistakes, which is why it scrutinizes these withdrawals.
If you’re a freelancer or sole proprietor, then you get a host of tax deductions that aren’t available for employees. Many self-employed individuals try their best to maximize their itemized deductions to reduce their taxable income. There’s nothing wrong with this strategy, but some people take it too far.
As a result, they end up claiming deductions that they don’t have any proof to limit their tax bill. The IRS is well aware of this practice, and any discrepancies brought to its attention by the DIF will trigger an audit.
For instance, the DIF won’t sound the alarm bells if you claim 15% of your income in travel expenses for the year. However, if you try to slip 30% of your income into this deduction, it might cause a red flag by the system. You can expect a call from an IRS agent, and you had better be able to prove your expenses.
You Have a Home-Based Business
If you work from home, then you qualify for a few itemized deductions, including your home office. The IRS realizes that many taxpayers don’t get the math right when filing for this deduction. The primary rule that most taxpayers don’t adhere to is the office space in their home. The IRS rules stipulate that you must use the area of your home, which houses your office for business purposes only.
Therefore, if you set up your office in your bedroom, that doesn’t qualify. If you want to be eligible for the home office deduction, there must be nothing going on in that area of your home than work or business. Take a look at IRS Publication 587 when filing your deduction for the home office.
You Have a Cash Business
If you own a cash business where customers are handing you physical cash in return for services, this behavior can also trigger an audit as well. Companies like car washes, hair salons, bars, restaurants, or taxi services are all on the IRS radar for potential under-reporting of income.
If your lifestyle exceeds your income, then you can expect to get a call from the IRS asking you about where the money is coming from to fund your activities. You might think that it’s next to impossible for the IRS to determine what kind of lifestyle you live. However, it might surprise you to learn that the IRS accepts tips from the public, and your nosey neighbors might report you to their hotline.
You Claim a Hobby as Your Business
Perhaps you breed pitbull pups and sell them to the public – does this mean that you’re self-employed? It might, but there are rules and regulations in place to determine the distinction between a hobby and a business.
As a self-employed person, you get to claim for Schedule C deductions on your return. However, if your business is a hobby, then you can’t claim these tax breaks. A few years ago, you could deduct your expenses to the threshold of the income you receive from your hobby if you itemize your deduction.
However, the TCJ Act repealed this deduction. The IRS does not qualify your hobby as a legitimate business unless it earns a net profit in three of the previous five years. If you’re only starting your business venture now, then you can file Form 5213, which gives you four years to produce a profit from your new business.
However, filing the form can sometimes lead to the IRS, putting you under the microscope.
You Have Cash or Assets in other Countries
The IRS has a particular interest in those Americans with cash or assets held outside of the United States. In recent years, the IRS ramped up its investigation of Americans hiding cash or assets in foreign countries that have favorable tax laws.
The IRS works with the international banking community, and it can access your accounts in other countries if it has agreements with the state government. Some foreign banks have to provide the IRS with a list of American taxpayers using the facility.
As an American taxpayer, you have an obligation to report all foreign accounts with balances greater than $10,000, using FinCEN Form 114. For those that have foreign assets valued over $50,000, you must list them on Form 8938.
You can exp0ect the IRS to look into your accounts to make sure the figures match your returns. Any discrepancies will trigger an audit.
You Make Income from Investments
It’s important to note that the IRS gets copies of all of the forms you receive featuring your Social Security number. If you have investments, then it might be very easy for you to overlook some of the forms. Make sure you keep your eye out for 1099 forms arriving after the first calendar day of the new year. You can bet that the IRS is watching.
If the IRS receives 1099 forms showing that you received dividends or interest payments, and you failed to report them on your tax return, you’re in trouble. You can expect to receive a letter of inquiry from the Washington office about your lack of reporting.
However, it’s important to note that if you own up to the mistake and agree to pay the back taxes, it shouldn’t lead to a comprehensive audit of your financial affairs.
You Claimed for the Earned Income Tax Credit (EITC)
If you decide to claim for the Earned Income Tax Credit, you can expect to trigger an immediate audit by the IRS. However, in most cases, you won’t even know the audit takes place. The EITC refundable tax credit increases with every child dependent you decide to claim.
If you’re eligible for the credit, then the IRS looks at any taxes you owe, and if the amount of the credit is greater than the taxes, they send you a refund check to cover the difference. However, since these are government credits, there’s an incentive for the IRS to check in on your situation and review your position.
As a result, you’re more likely to trigger an audit, especially if the federal government has to write you a check. There are also income limits to applying for this tax credit. Therefore, the government will also want to see that you’re not taking these benefits away from people that need them.
The Protecting Americans from Tax Hikes (PATH) Act requires the IRS to hold off on issuing these refunds until mid-February.
Wrapping Up – Tax Builds the Nation
While there’s plenty of incentives to help you pay less tax, it’s essential that you pay your share. Taxes build roads and hospitals, and they take care of you financially when you’re older. There’s no reason not to try and save on your tax bill, but make sure you pay your dues.