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No taxpayer wants to have to deal with an audit, but unfortunately, they do occur. Because facing an audit can be very time-consuming and stressful, it’s important to avoid this situation in whatever way you can. Many people don’t realize that there are several circumstances that can trigger an audit by the IRS, and understanding these situations will help you limit your chances of receiving an audit notice. Here are a few of the most common IRS audit triggers that you should be aware of to avoid frustration.
The IRS receives millions of tax returns every year and to manage these returns, the agency uses something known as the Discriminant Inventory Function System (DIF). This system scans every tax return received by the IRS, and if it detects something unusual with the return, it will flag it for further inspection by an IRS agent. A return being flagged by the DIF system is typically the first step in an audit.
If you want to avoid an audit, you need to make sure that your return is correctly prepared so that it won’t be flagged by the DIF system. When the system scans your return, it searches for a variety of issues. Being aware of these issues can potentially help you avoid an audit.
For instance, when filling out your return, you must be certain that the income you are reporting matches the income listed on your 1099 or W2. The IRS receives copies of these documents, so the agency will know exactly how much you have earned.
The DIF system also scans the Social Security numbers listed on a return. If two different taxpayers try to claim the same dependent, the system will detect that the dependent’s social security number is listed on two returns and will then flag those returns.
To avoid having your return flagged, potentially resulting in an audit, you should double-check everything on your return before submitting it to the IRS. Make sure that all the information is correct, and that you have included all necessary documents. You may want to use some form of tax preparation software or hire a tax professional to make sure you’ve completed your return correctly.
An IRS audit can be triggered in a variety of ways, but the most common reason you may face an audit is the failure to report all of your income. Fortunately, this is also the easiest audit trigger to avoid.
Most people that fail to report all their income aren’t doing so intentionally. For instance, if you work for multiple institutions and have multiple sources of income, you simply may have lost track of some of the money that you earned. Some sources of income that are easy to forget to report include:
Every tax form that you are sent will also be received by the IRS, and this includes distributed income. The IRS will compare the income listed on these forms to what you reported on your tax return. If they don’t match, an audit will be initiated.
Having foreign bank accounts can also result in an IRS audit. Under the Foreign Account Tax Compliance Act, there are very strict rules for reporting money stored in foreign accounts. First, the foreign banks must inform the IRS of any account holders who are also United States citizens. Second, taxpayers who own foreign assets worth $50,000 or more must report these assets on IRS Form 8938.
Previously, reporting foreign assets only required checking a box on your tax return. Now, there are three different steps to report foreign assets:
Transparency is the point of these new regulations. Unfortunately, these regulations also mean that taxpayers with foreign bank accounts are also much more at risk for an audit, both because it can be easy to make a mistake with these reporting requirements and because possession of a foreign bank account is often perceived as an attempt to hide money from the IRS.
Lowering their tax burden is a goal of most business owners. If you own a business, you will likely want to take advantage of as many available tax deductions as possible. While this is understandable, it also means that you’ll be increasing your chances of facing an audit.
If you take a large amount in business tax deductions, the IRS will examine your taxes very carefully. Imagine, for example, that you frequently need to travel for your business. The IRS keeps a list of different professions and their typical travel amounts. If you deduct 20 percent more travel time than is standard for your profession, then an audit and tax debt are likely.
Incorrectly deducting a business vehicle is another reason you might have to deal with an audit. For instance, if you take a vehicle home, it generally won’t be considered a business vehicle, even if you do use it for work. You should always list a business purpose when deducting a vehicle.
Failing to separate personal and business expenses may also result in an audit. Deducting business meals can often be tricky, particularly if you are deducting more than the norm for your profession. Take too many deductions for business meals, and an audit may very well be in your future.
The amount that you earn can also contribute to your likelihood of being audited. Typically, 1 percent of IRS audits are for taxpayers reporting less than $200,000 in earnings. If you earn above this threshold, your chances of being audited will increase. The more you earn, the more likely an audit becomes.
The reason that higher-earning individuals and businesses are more at risk for an audit is that their tax returns are more complicated than those who earn less. The IRS also wants to maximize the taxes that they collect, and auditing higher earners usually results in more taxes collected than auditing people and businesses that earn less money.
In an increasingly digital world, cash transactions are becoming a thing of the past, which is why the IRS views large cash transactions as suspicious. Businesses must report large transactions to the IRS. Typically, these transactions are $10,000 or more. If you spend this much money in cash as an individual, you can expect an audit notice in your mailbox.
The reason that large cash transactions can result in an audit is that it can be difficult to determine the origin of this money. Imagine that you’ve been saving for a used car and take $10,000 out of your bank account to pay for the car. Then, you take this money to a dealership to purchase your car. Because of the previously mentioned reporting requirement, the dealership will notify the IRS of the transaction, and due to the amount, the agency will probably contact you for more information. In particular, they may request documentation of where and how the money was earned.
Operating a cash-only business is another common audit trigger. The IRS’s assumption is that cash-based businesses can more easily hide income since they may not document most transactions. The biggest red flag is if the deductions on your tax return reflect a lifestyle that doesn’t match the income you are reporting for your business.
When you’re facing a tough financial situation, it’s common to look for any solution for getting your finances back in order. For example, if you’re suddenly facing a large amount of debt, it may be tempting to dip into your retirement fund to get yourself out of debt. If you decide to take money out of your retirement fund early, you may face an audit in your future.
Taking money out of an IRA or 401(k) before you are actually retired is another common audit trigger. The reason that this can result in an audit is that people who dip into their retirement fund typically make mistakes on their tax return related to this money. Auditing for this issue is more about the IRS making sure that it gets the money that it’s owed than it is about preventing fraud.
The mistake that many taxpayers make when dipping into their retirement fund is failing to pay the early withdrawal penalty. If you take retirement money early and are 59.5 years old or younger, you must pay a 10 percent penalty. If you’re older than this and take a withdrawal, you won’t need to pay a penalty, but income taxes will usually apply to the money you withdrew. There are certain situations where the early withdrawal penalty will not apply:
While every taxpayer can find themselves facing an audit, IRS audits are much more common for those who work as freelancers or sole proprietors. The reason for this is that freelance workers and sole proprietors have access to a variety of deductions, and as we’ve discussed, the more deductions that you take, the likelier an audit. Sole proprietors and freelancers can take deductions for the following issues, among others:
These deductions must be reported on a Schedule C form. To determine the amount of taxable income, the deductions are subtracted from the freelancer’s or sole proprietors’ total revenue. As with traditional business deductions, sole proprietors and freelancers claiming deductions outside the norm for their profession will likely be audited. For example, if a typical freelancer in your industry claims a 20 percent deduction for travel expenses, and you claim 40 percent, you may end up having to deal with an audit.
Another reason that the IRS may audit your tax return is that you try to claim that your hobby is actually a business and then try to take advantage of business deductions. The IRS has a variety of rules that it uses to distinguish hobbies from businesses and failing to understand these rules can result in an audit. For your hobby to reach the level of a business, you must have earned a net profit in three tax years out of the last five.
As you can see, there are countless reasons that you may find yourself dealing with an audit, which means you need to make sure you’re prepared for this common tax issue. In particular, you need to be sure that you aren’t throwing away your tax returns and related documents too early.
When the IRS initiates an audit, it will request a wide variety of documents, including copies of your old tax returns. If you no longer have these returns, it can make the audit process much more difficult, and it may increase the chances of an unfavorable result.
Generally, you should keep a tax return until the audit statute of limitations has expired, which for federal tax returns is three years after the return was filed. Your state taxing authority may have a longer statute of limitations, so you should check the rules in your state before throwing away your state returns. In addition to copies of your tax returns, other documents that you should save include:
The biggest fear of most people facing an IRS audit is that they’ll eventually need to pay back taxes. Fortunately, with the help of Solvable, you can deal with your tax debt quickly and easily. We’ve connected thousands of people with the best debt relief companies in the country, and we are here to do the same for you. To get started, read our debt relief company reviews or contact us with your questions.
Jill writes for Solvable covering financial freedom through debt resolution.