Did you know that the IRS chooses which tax returns to audit based on the phases of the moon? No? That’s because it’s not true. But it would be far more interesting than how they actually do it.
In reality, the IRS uses an advanced computer program called the Discriminant Function System (DIF) to choose which returns to audit. Every tax return submitted to the IRS is assigned a score by the DIF indicating how likely it is to be incorrect. A high DIF score means the return gets flagged and is then manually reviewed by an actual human, probably named Tammy. If Tammy finds that the info on your return is questionable, you’ll have to tell her where all your gold is buried because you’re getting audited.
None of us mere mortals know exactly what the DIF algorithm is, but we accountants do know a few red flags that may upset the DIF and trigger an audit.
1. High Deductions
The IRS receives a metric ton of information about pretty much everyone in the US. So they can easily tell what the average deduction amounts are for every income level. For example, the average person with an AGI between $100,000 and $200,000 claims a charitable contribution of just over $4,000. So if your AGI is $125,000, and you write off $40,000 in charitable contributions, the IRS may want to speak with you.
2. Foreign Accounts
Uncle Sam wants his money, and he has made a whole lot of it (literally billions of dollars) by forcing foreign banks to disclose account info for US citizens. If you have money in a foreign account that you fail to disclose on your tax return, it could result in severe penalties.
3. Early Withdrawals from Retirement Accounts
The IRS says that you can withdraw as much money as you like from your 401(k) or traditional IRA and pay the regular, marginal tax rate on that withdrawal as long as you are over age 59 ½. If you make those withdrawals earlier than that and don’t meet strict exemption guidelines, you face a 10% penalty on top of the regular tax rates. That’s like icing on the cake to the IRS. If you don’t give the IRS their icing, they are going to come after you for it.
4. Gambling Winnings & Losses
If you win a few hundred bucks at the casino, congratulations! You now have to pay taxes on your winnings. Casinos typically report large winnings to the IRS, so don’t think they won’t find out about it. Big Brother is watching you.
Deducting gambling losses can also be risky. The amount of losses you deduct can’t be more than the amount you won. Plus, you can only write off costs related to lodging, meals and other gambling-related expenses if you are a legit professional gambler, which in all likelihood, you are not.
5. Business Losses
Most businesses don’t make a profit in their first year. But if you’re reporting a business loss for several years in a row, the IRS may declare your “business” a hobby. Losses from a hobby are not deductible, and the IRS can make you pay back the deductions you took in previous years with additional penalties and interest.
6. Excessive Meal & Entertainment Expenses
Thinking of throwing the party of the century and writing it off on your taxes? Don't. Whether you take these deductions as a business owner or an employee, the IRS is going to be interested in any amounts they consider larger than average. To prevail in an audit, you must have detailed records that show the expense amount, place, people attending and business purpose. Get in the habit of keeping receipts and writing any additional details on them. You can then scan them and keep the digital copies for your records.
7. Home Office Deductions
If you work or run a business out of your home, you are eligible for the home office deduction. However, that doesn’t mean you can deduct the square footage of your guest room just because you have a computer in the corner. If you legitimately use a space in your home exclusively for business, you can deduct either a percentage of your rent, real estate taxes and utilities OR $5 per square foot of space used for business. Claiming this deduction may slightly increase your risk of audit, but claiming it in addition to a loss for your business is asking for trouble.
8. Business Use of Vehicle
Claiming that your vehicle is used for business 100% of the time is like dumping a bucket of chum in the ocean – the sharks at the IRS will instantly be drawn to your return. This is especially true if you have no other vehicle available for personal use.
Another red flag is claiming more than average mileage for your business vehicle. Remember, the IRS has ALL the data, so they know what the average is for your industry. If you claim you drove 40,000 miles as an Uber driver, that might be okay (if you work 24 hours per day). But if you claim that for your web design business, they are definitely not going to approve. Either way, it’s vital that you keep detailed mileage logs to prevail in an audit. Consider using an app such as MileIQ (affiliate link here) to easily track business mileage for year-end tax reporting.
Less than 1% of taxpayers are audited, so you probably have nothing to worry about. But you really don’t want to be part of that 1%, as it will likely mean you lose lots of money to retain representation and pay fines, penalties, and interest.
You can decrease your odds of being audited to near zero by hiring a CPA to do your taxes. I happen to know a guy if you’re interested. ;-)
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