IRS Audit Red Flags: Understand Who & When the IRS Audits
IRS red flags are another name for the Discriminant Function System (DIF) used by the IRS to generate a tax return score. The higher the DIF score, the more likely it is for the tax return to be audited. While it is not known exactly how the IRS computer system works, many tax professionals do know which factors the IRS weighs more than others. The IRS actually uses three different computer systems to check for different types of red flags.
Some red flags don’t always lead to an audit, they are all considered by the computer program and weighted together to determine if the return should be audited. Pretty much what the computers do is a complex statistical analysis of each tax return and if the return falls outside of statistical norms then it will likely be flagged. Most of the time when the IRS computer has flagged a return it will be manually reviewed by an IRS employee to determine if the return should be audited.
Individuals and small businesses both have different red flags because of the difference in the nature of both. Below are the most common individual tax return red flags and most common small business tax return red flags.
Individual Tax Return Red Flags
These are the most common red flags for personal tax returns.
- Rounded numbers: The likelihood of your investment earnings or your mortgage interest being a rounded number is very unlikely. The IRS knows that if numbers are rounded there is a higher chance that the person filling out the tax return is not using actual numbers. Don’t panic if you do see that your investments actually came out to a straight $1,000.00, normally a flag won’t be triggered unless there are a few instances of rounded numbers.
- Unreported income: If you fail to report income the IRS will catch this through their matching process. It is required that third parties report taxpayer income to the IRS, such as employers, banks and brokerage firms. If the IRS notices that a third party reported that they paid you income but you don’t have that income reported on your return this immediately lifts a red flag.
- Sloppy or incomplete information: One of the biggest red flags is if the tax return has math errors or is not complete. It is always smart to use tax software that checks everything electronically, these can be some of the easiest errors to avoid.
- Charitable donations: Charitable donations are great but the IRS has found that many abuse this deduction, which is why the IRS will look into many large charitable donations. The IRS knows what the average charitable donation amount is for someone of your income bracket and if you donate more than the average this will raise a red flag. If you are a generous person, just be sure to keep all records of the transactions to prove to the IRS if they ask.
- Earning over 100K: The IRS likes to focus their efforts on the individuals that they can justify the expense of the audit. Individuals that make over $100,000 are 500% more likely to get audited than people making under that. This is one of those flags that you cannot help, it is just a fact that the IRS audits people with higher incomes at a much higher rate.
- Low income for profession: The IRS computer knows what someone of your profession and location makes on average. If you report a number that is significantly lower than what the IRS would expect then that could be a red flag. If you get audited for this reason and reported everything correctly, then it is probably time for you to request a raise.
- Differences in Federal and State tax returns: If there are differences in what is reported on each of these, you can expect red flags to go up for the IRS and for the State. Be sure these are consistent, using a tax preparation software can help with this and make sure there are no differences when you file.
- Large swing in income: The IRS thinks that there should be consistency to earnings. If there are large swings of reported income that cannot be explained by W-2s or 1099’s, this is a red flag. This is another one of those red flags you can’t avoid if you do have large swings in income. If you do expect to have large swings, just be prepared to show documentation for the differences.
- Job Expenses: Typically most people cannot take job expense deductions if they are a W-2 employee. There are cases that this is allowed if certain conditions are met. The IRS knows that not many people actually meet these conditions and far more people take the deduction than actually qualify to take it, therefore it is a red flag to take job expense deductions if you are a W-2 employee.
- Tax avoidance transactions: Sometimes there are incriminating documents that are turned over to the IRS from the IRS’s efforts to identify participants in tax avoidance transactions. This can happen when the IRS gets the courts to companies that are promoters of tax avoidance schemes to hand over documents related to these transactions. These transactions can point out individuals that have taken part in tax avoidance transactions.
Small Business/Self Employed Tax Return Red Flags
These are the most common red flags for small business/self-employed tax returns.
- Home Office Deductions: Since the IRS has allowed home office deductions they have been abused. There are many cases where these are legitimate deductions but many times people do overstate them or misuse them, which is why the IRS investigates these types of deductions more than any other. Typically the IRS will look at your profession and prior tax filings as well to determine how much weight to put on this red flag. If you are taking a home office deduction and it is legitimate, be sure to have the proper backup to support it if any questions do arise.
- Filing a Schedule C: Studies have shown that people that file a Schedule C are much more likely to get audited than individuals that don’t. If you do file a schedule C, be sure to have all the documentation to back up your deductions that you have taken. You can also consider forming a separate business entity (LLC, S Corp, Corporation) and flowing expenses through there instead of the Schedule C.
- Entertainment deductions: This deduction has been abused quite a bit in the past and many people try to get away with putting too many entertainment or business meal expenses on the business when most are not allowed. This will raise a red flag if the amount charged seems too large compared to the business size.
- Losses reported from hobby instead of business venture: The tax code does not permit individuals to deduct hobby expenses on their tax return. If you have claimed expenses on a Schedule C that show a loss the IRS may look into this further because it looks like you could be flowing through hobby losses as a business loss. The IRS will require you to prove that this is a legitimate business if they audit you for this reason.
- Low Income with large deductions: Many times when small businesses report low income and large deductions they tend to be claiming more than is actually allowed. While this could be legitimate, especially for newly formed companies or companies having not so great years, the IRS may look into this further.
- Claiming a loss on the business: Claiming a loss on a business is a red flag right away because this means that no taxes will be paid on the businesses and the IRS thinks that you may take deductions that are not allowed in order to pay any taxes.As you can see there is a common theme going on with red flags and small business.
If your tax return has any audit red flags it doesn’t mean that you have done something wrong, many times your return is perfectly fine, but statistically speaking from the IRS perspective it is in their best interest to investigate a bit further. Being aware of common IRS audit red flags can help you make sure you keep proper documentation on items the IRS does consider as flags.