Self-employed individuals and small businesses may be at greater risk of an Internal Revenue Service (IRS) audit than most. No one is immune, however, as the IRS conducts random audits as a matter of course. The people who undergo an audit have been selected due to a number of red flags that the IRS’s computer-based system has detected.
In this article, we’ll examine the nature of IRS audits, the common audit red flags that result in IRS scrutiny, and how professional tax advisors can help reduce the risk of you being audited.
Table of Contents
- What does it mean to be audited?
- Common mistakes that can trigger an IRS audit
- What should you do if you’re audited?
- How Harness can help
- FAQs
What does it mean to be audited?
An IRS audit is a formal review of your financial records to verify their accuracy and compliance with tax laws. The IRS uses various methods to conduct these audits, ranging from simple correspondence audits handled via mail to more comprehensive field audits conducted in person.
Typically, the IRS focuses on auditing returns from the past three years. However, if the IRS uncovers major errors or suspects fraud, they can extend their review period to the past six years or even longer. As a result, it’s important to maintain thorough and organized records for at least three years and, ideally, six. If you fail to file a tax return at all, the IRS can audit you indefinitely.
Common mistakes that can trigger an IRS audit
There are a number of key red flags—ranging from mistakes made on tax returns to specific financial circumstances—that can attract IRS scrutiny. Some of the most common red flags include:
Not reporting all of your income
The IRS operates on a system of information matching. They receive copies of W-2s from employers, 1099s from clients, and other income-reporting documents. When your reported income doesn’t align with these third-party sources, it creates a discrepancy.
These discrepancies are a primary audit trigger as they strongly suggest underreporting. Even small discrepancies can initiate an IRS audit, so it’s important to maintain accurate records of all income sources and carefully reconcile them before filing.
Claiming business losses year after year
While many businesses experiencing temporary setbacks may report losses, consistently showing losses raises suspicion. The IRS may question whether your business is a genuine profit-seeking venture or a hobby disguised as a business.
As a result, the IRS may apply the “hobby loss rule,” which limits deductions for activities not engaged in for profit. To avoid this, you need to demonstrate a clear profit motive, maintain detailed business records, and show efforts to generate income.
Math errors and typos
Minor mathematical errors and typos can disrupt the IRS’s automated processing systems and can result in discrepancies that can flag your return for manual review.
Even if the error is easily corrected, it can delay your refund and increase the likelihood of further scrutiny. You should consider using tax preparation software or consulting with a tax professional. Either way, you need to have confidence in the calculations and entries submitted, as you’re legally responsible for them.
Deducting business vehicles, meals, travel, and entertainment:
Business deductions are a common source of tax errors and abuse, as they often involve a mix of personal and business expenses. Consequently, the IRS is particularly vigilant in this area.
To avoid scrutiny, maintain detailed logs of business-related expenses, making sure that all deductions are directly related to business activities and are supported by proper documentation, such as receipts and itineraries.
While self-employed taxpayers can deduct legitimate business vehicle costs, claiming 100% business use of a vehicle is a major red flag for the IRS, especially if you don’t own a second vehicle.
High income
While having a high income isn’t a “tax mistake” by any means, it does mean that any discrepancies on high-income tax returns are likely to be larger. As a result, the IRS will pay closer attention. The higher your income, the greater the audit probability, with 8.5% of individuals earning $10 million or more audited by the IRS between 2012 and 2020.
Home office deductions
The IRS has strict requirements for claiming the home office deduction. The space must be used “exclusively and regularly” for business, and it must be your “principal place of business.” Mixing personal and business use of the space, or claiming an excessive amount of space, will raise red flags.
It’s important to keep detailed records of the space used for business and make sure it meets the IRS’s criteria.
Charitable donations
Overstating the value of donated items, failing to properly document non-cash contributions, or claiming deductions for ineligible organizations can trigger an audit. The IRS carefully scrutinizes these deductions to ensure compliance with strict valuation and documentation requirements. You should obtain appraisals for high-value donations and obtain receipts for any contributions.
Foreign accounts
Failure to report foreign bank accounts, financial assets, or income can result in severe penalties and trigger an audit. The IRS has intensified its efforts to combat offshore tax evasion, and unreported foreign holdings are a major red flag, especially with increased information sharing between countries.
U.S. taxpayers must file FinCEN Form 114, reporting any Foreign Bank and Financial Accounts (FBAR) exceeding $10,000, and IRS Form 8938 for foreign assets. While FinCEN handles FBAR filings, the IRS enforces compliance for both.
Earned Income Tax Credit (EITC)
Due to the complexity of EITC’s eligibility requirements, this specific credit is frequently audited. Claiming the credit without meeting income, family status, or residency rules can trigger IRS scrutiny. Carefully review the eligibility requirements and maintain accurate records to support your claim.
Digital asset transactions
Underreporting crypto gains, misclassifying transactions, or failing to report transactions altogether can result in an IRS audit. The complex nature of digital assets, in conjunction with the changing regulations that surround them, means that accurate reporting is absolutely vital.
You need to keep detailed records of all digital asset transactions, and you’re strongly advised to consult with a tax professional to maintain compliance.
Taking early withdrawals from retirement accounts
Withdrawals before age 59½ are scrutinized due to the potential complexity of penalty exceptions. Incorrectly claiming exemptions or failing to properly report withdrawals result in a higher probability of IRS scrutiny. Carefully review the rules for early withdrawals and maintain accurate records to support any claimed exceptions.
Large amounts of cash transactions
Businesses or individuals handling significant cash amounts are flagged due to the potential for unreported income or money laundering. For cash payments exceeding $10,000, businesses are required to file Form 8300. Any failure to report these transactions can result in an IRS signal of illicit financial dealings.
What should you do if you’re audited?
Receiving an audit notice may be stressful, however, a calm response is the key to a smooth resolution. First, carefully review the notice and gather the requested documents. For most audits, conducting the process by correspondence will be enough. Complex cases or situations involving substantial sums, however, may require professional help.
An experienced tax professional can streamline IRS audit procedures, ensuring accurate documentation and effective representation. Professional tax guidance not only minimizes the stress of an IRS audit but will help maintain compliance and can reduce your tax liability.
How Harness Can Help
A tax advisor from Harness can help you avoid tax mistakes and reduce the likelihood of an audit. Our advisors can offer personalized guidance on appropriate tax deductions, accurate record-keeping, and staying compliant with all applicable tax laws.
In the event that you are audited, a Harness tax advisor can provide the insight and support needed, representing you before the IRS and helping you navigate the process.
FAQs
Here are the answers to the most frequently asked questions about IRS audits.
What is an IRS audit?
An IRS audit is a formal review by the IRS, examining your tax return to verify the accuracy of your reported figures. This process ensures compliance with tax laws, scrutinizing income, deductions, and credits for potential discrepancies or errors.
What types of income are considered taxable income?
Taxable income includes wages, salaries, self-employment income, investment income, and certain other types of earnings. Taxable income is the portion of your gross income that’s subject to taxation after permissible deductions and exemptions.
What are the most common IRS audit triggers?
Key IRS audit triggers include inconsistencies between your reported income and data from third-party sources, like W-2s and 1099s. Additionally, consistently reporting business losses, claiming overly inflated deductions for items like vehicles or home offices, and failing to disclose foreign accounts can raise red flags. These discrepancies prompt the IRS to conduct further investigations to ensure tax compliance and accuracy.
What are itemized deductions?
Itemized deductions offer taxpayers a way to lower their taxable income by subtracting eligible expenses from their adjusted gross income. This contrasts with the standard deduction, allowing for a more tailored approach.
Common examples include deductions for medical expenses exceeding a certain percentage of income, state and local taxes up to specified limits, and charitable contributions to qualified organizations. Taxpayers can potentially achieve a significantly reduced tax burden by carefully documenting these expenses.
That said, it’s important to understand the specific rules and limitations associated with each deduction type to maximize benefits and maintain compliance.
Are small business owners more likely to face an IRS audit?
Small business owners are more susceptible to IRS audits due to the intricate nature of business deductions and the increased likelihood of unreported income. While taxpayers may face an audit, the IRS dedicates significant resources to examining business returns.
This heightened scrutiny aims to ensure meticulous tax compliance, verify accurate financial reporting, and uphold the integrity of the tax system concerning business operations. The complexity of business finances necessitates careful documentation and adherence to regulations to reduce audit risks.
What is the difference between an IRS audit and a tax audit?
There is no distinction—an IRS audit and a tax audit are synonymous. The Internal Revenue Service is the sole entity responsible for conducting these audits, ensuring taxpayers adhere to federal tax regulations and reporting requirements.
Which tax year is typically audited by the IRS?
Generally, the IRS focuses its audit efforts on the past three tax years, aiming for timely compliance checks. However, the scope can extend to six years or more when significant errors or potential fraud are suspected. This extended timeframe allows the IRS to conduct thorough investigations, ensuring accurate tax reporting.
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