Filing taxes can be a stressful experience for many people, and the thought of an IRS audit often adds to that anxiety. While the chances of being audited are relatively low for most taxpayers, certain financial behaviors and situations can increase the likelihood of the IRS taking a closer look at your tax return.
In this post, I outline 19 financial red flags that could potentially trigger an IRS audit.
Unreported Income
Failing to report all your income is a major red flag for the IRS. This includes income from side jobs, freelance work, or investment earnings. The IRS receives copies of your W-2s and 1099 forms, so they can easily spot discrepancies. Always report all income, no matter how small, to avoid potential audits and penalties.
Large Charitable Donations
While charitable giving is encouraged, unusually large donations relative to your income can trigger suspicion. The IRS has data on average donation amounts for various income levels. If charitable deductions seem disproportionate to your income, be prepared to provide documentation. Keep detailed records of all donations, including receipts and acknowledgment letters from charities.
Home Office Deduction
Claiming a home office deduction can be legitimate, but it’s often misused. The space must be used exclusively and regularly for your business to qualify. Trying to deduct your entire living room because you sometimes work from the couch won’t fly with the IRS. Be accurate in measuring your office space and only claim the portion truly dedicated to work.
Round Numbers
Using too many round numbers on your tax return can look suspicious. Actual income and expenses rarely come out to even amounts. If your deductions are all multiples of $100 or $1000, it might suggest you’re estimating rather than using actual figures. Keep detailed records and use exact numbers, even if they’re not as neat and tidy.
High Income
While not a red flag in itself, having a high income does increase your chances of being audited. The IRS tends to focus more on high-income taxpayers because there’s potentially more to recover. If you’re in a high-income bracket, be extra diligent about keeping records and accurately reporting all income and deductions.
Claiming 100% Business Use of a Vehicle
It’s rare for someone to use a vehicle solely for business purposes. If you claim 100% business use of a car, the IRS might be skeptical. Keep a detailed mileage log and be honest about personal use. It’s better to claim a lower, accurate percentage than to risk an audit by overstating business use.
Cash-Heavy Businesses
The IRS might pay closer attention if you own a business that deals primarily in cash. Cash transactions are harder to verify, so there’s more potential for underreporting income. Keep meticulous records of all cash transactions. Consider using a point-of-sale system that tracks cash sales to help support your reported income.
Large Business Meal Deductions
While business meals can be deductible, claiming an unusually high amount in this category can raise red flags. The IRS knows that some people try to pass off personal meals as business expenses. Keep detailed records of who attended the meal, the business purpose, and the amount spent. Only claim legitimate business-related meals to avoid scrutiny.
Hobby Losses
Repeatedly claiming losses for a hobby-like activity can attract IRS attention. If your “business” consistently loses money year after year, the IRS might view it as a hobby rather than a for-profit venture. To claim business losses, be prepared to show that you’re actively trying to make a profit. Keep records of your efforts to improve profitability and treat the activity like a real business.
Rental Property Losses
Claiming rental property losses when you’re a high-income earner can be a red flag. The IRS has specific rules about who can claim these losses based on income levels and level of involvement in managing the property. If you’re claiming rental losses, make sure you meet the criteria for “active participation” and that your income doesn’t phase out your ability to claim these losses.
Cryptocurrency Transactions
With the rising popularity of cryptocurrencies, the IRS is paying more attention to these transactions. Failing to report cryptocurrency gains or losses can trigger an audit. Keep detailed records of all your crypto transactions, including dates, amounts, and the fair market value at the time of the transaction. Report all crypto income, even if you didn’t receive a 1099 form.
Large Cash Deposits
Making large cash deposits can raise suspicions about unreported income. Banks are required to report cash transactions over $10,000, and making multiple smaller deposits to avoid this threshold (known as “structuring”) is illegal. If you have a legitimate reason for large cash deposits, keep detailed records of the source of the funds.
Claiming the Earned Income Tax Credit
The Earned Income Tax Credit (EITC) is a valuable benefit for low to moderate-income workers, but it’s also a common area for tax fraud. The IRS scrutinizes EITC claims closely. If you claim this credit, make sure you meet all the eligibility requirements. Double-check your income calculations and be prepared to provide documentation if asked.
Discrepancies Between State and Federal Returns
Your state and federal tax returns should tell the same story. Large discrepancies between the two can trigger audits from both state and federal tax agencies. When preparing your returns, cross-check the information to ensure consistency. If there are legitimate reasons for differences, keep documentation to explain these discrepancies.
Claiming Too Many Business Expenses
While business expenses are deductible, claiming an unusually high amount relative to your income can raise red flags. The IRS has data on average expense ratios for various industries. If your expenses seem out of line with norms for your business type, be prepared for extra scrutiny. Keep detailed records and receipts for all business expenses, and only claim legitimate, necessary costs.
Misreporting Alimony
Recent changes in tax law regarding alimony make this area ripe for mistakes. For divorces finalized after 2018, alimony is no longer deductible for the payer or taxable for the recipient. However, for older divorces, the old rules still apply. Make sure you’re following the correct rules based on when your divorce was finalized. Keep records of alimony payments and the divorce agreement.
Early Withdrawals from Retirement Accounts
Taking money out of retirement accounts before age 59½ can result in penalties, unless you qualify for an exception. The IRS pays attention to early withdrawals to ensure people aren’t avoiding taxes or penalties improperly. If you need to withdraw early, understand the rules and exceptions. Keep documentation of why your withdrawal qualifies for an exception, if applicable.
Foreign Bank Accounts
If you have foreign bank accounts, you’re required to report them if the total value exceeds certain thresholds. Failing to report these accounts can lead to severe penalties. The IRS has been cracking down on offshore accounts in recent years. If you have foreign accounts, make sure you’re complying with all reporting requirements, including filing a Foreign Bank and Financial Accounts report if necessary.
Math Errors
While not always a deliberate attempt to deceive, math errors on your tax return can trigger IRS scrutiny. Simple addition or subtraction mistakes can make the IRS wonder what other errors might be lurking in your return. Double-check all calculations before submitting your return. Consider using tax preparation software or a professional tax preparer to minimize the risk of math errors.
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