The Internal Revenue Service doesn’t have time to review every single tax return for accuracy, but that doesn’t mean all tax returns have an equal chance of being audited. While the tax collection agency audits less than 1% of all individual tax returns, the risk of an audit escalates depending on a variety of different factors, including income, deductions, business activities, and whether or not clients own foreign assets, among other things.

In this article, we’ll take a look at some red flags that financial advisors may want to warn their clients about in order to help them avoid the dreaded IRS audit. (For more, see: Audit Stories You Won't Believe.)

Income Considerations

The first category of triggers relates to declared income on tax returns. While income is positively correlated with audit risk, most clients probably aren’t looking to take a pay cut in order to reduce their risk by a few percentage points. Clients should instead focus on minimizing other income-related audit risks in order to lower relative risk with their current level of income rather than lowering their absolute risk by reducing income. (For more, see: What to Do if You Get Audited.)

Some important income-related risks include:

  • Taxable Income Failing to report all taxable income is generally a bad idea, since the IRS can simply match up 1099s and W-2s to find discrepancies. Be sure to report all taxable income on tax returns in order to avoid any problems.
  • Schedule C Abnormalities – Cash intensive Schedule C businesses can lead to greater scrutiny, while large Schedule C net losses may be suspicious. Consider moving Schedule C activities on a personal return into a separate LLC or S-Corp entity.
  • Gambling Winnings Failing to report gambling winnings can result in a quick audit, since these winnings are reported by casinos above a certain amount. In general, it’s a good idea to set aside the tax money right away rather than waiting until April.

Deduction Risks

The second category of triggers relates to deductions on tax returns. Often times, individuals are tempted to maximize their deductions, but being too liberal can significantly increase the risk of an IRS audit, especially in certain categories. The key to success in this area is taking the right deductions and ensuring that the deduction amounts are so high that they trigger greater scrutiny of exactly where they are coming from in a tax return. (For more, see: 6 Tax Deductions That Might Get You Audited.)

Some important deduction-related risks include:

  • Disproportionate Deductions Disproportionately large deductions may automatically trigger an audit, especially for individuals at higher income levels. In general, it’s a good idea to work with an accountant to determine what’s reasonable.
  • Schedule C Deductions – Self-employed Schedule C deductions are closely watched by the IRS, with especially close attention paid to meals and entertainment deductions. Schedule A deductions may face similar criticism from the IRS.
  • Office and Vehicle Deductions – The IRS has strict rules regarding the home office deduction, which means that there’s a higher risk of an audit. Similarly, claiming 100% of a vehicle as a deduction may draw some scrutiny from the IRS. (For more, see: Avoiding An Audit: 6 "Red Flags" You Should Know.)

Asset Risks

The third category of triggers relates to declared assets. While assets aren’t usually a major consideration for an IRS audit, there are a couple important things that clients should watch. (For further reading, see How To Appeal Your IRS Audit.)

Two important asset-related risks include:

  • Foreign Accounts – Failing to report a foreign bank account can lead to heightened risk of an audit, especially if the accounts are located in international tax havens.
  • Large Transactions Suspicious activity or large transactions from bank accounts may draw attention from the IRS in the case of high net worth individuals. (For more, see: Avoid an Audit: 6 "Red Flags" You Should Know.)

The Bottom Line

The IRS doesn’t review every single tax return – in fact, less than 1% of them are audited – but there are several factors that may increase the risk of an audit, especially with high net worth clients. Financial advisors may want to ensure that their clients are aware of these risks in order to avoid any troubles down the road. (To learn more, read Surviving The IRS Audit.)

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