If history is any indicator, fewer than 1% of Americans will be audited by the Internal Revenue Service in the coming year. And while some of the audits are totally random and unrelated to any actions by the individual taxpayer, many are triggered by actions taxpayers themselves have taken.
Below is a list of "red flags" that can cause your return to be targeted by the IRS for review. Pay particular attention, as knowing what these triggers are can save you a lot of trouble and anxiety.
#1. Overestimating Donated Amounts
The IRS encourages individuals to donate things like clothes, food and even used cars to charities. It does this by offering a deduction in return for a donation. However, the problem with this system is that it is up to the taxpayer to determine the value of goods that are donated.
As a general rule, the IRS likes to see individuals value the items they donate at anywhere between 1% and 30% of the original purchase price (unless special circumstances exist). Unfortunately many, if not most, taxpayers either aren't aware of this or simply choose to ignore this fact.
There are several other tips that the taxpayer can use to ensure that they are valuing donated goods at a "fair" price. Aside from the 30% and under rule mentioned above, consider having an appraiser write a letter. (In fact, for individual items valued at $5,000 or more, an appraisal is required.). Another benchmark the IRS uses that could come in handy is the willing-buyer-willing-seller test.
This means that taxpayers should value their goods at a point or price where a willing seller (who is under no duress) would be able to sell his property to a willing buyer (who also is under no duress to purchase the item). Using such a benchmark will keep you out of trouble and prevent you from placing excessive value on items donated to charity.
#2. Math Errors
While this may sound simple, many returns are selected for audit due to basic math errors. So when filling out your tax return (or checking it after your accountant has completed the form) make sure that the columns add up. Also, make sure that the total dollar value of capital gains and/or losses are properly calculated. Even a small error can raise eyebrows.
#3. Failure to Sign the Return
A surprisingly large number of people simply forget to sign their tax returns. Don't be a part of this group! Failure to sign the return will almost guarantee additional scrutiny. The IRS will wonder what else you might have forgotten to include in the return.
#4. Under-Reporting Income
Tempting as it might be to exclude income from your tax return, it is vital that you report all money that you received throughout the year from work and/or from the sale of an asset (such as a home) to the IRS. If you fail to report income and get caught, you will be forced to pay back-taxes plus penalties and interest.
How can the IRS tell if you've reported everything? In some situations, it can't. After all, the system isn't perfect. However, a common way some individuals get caught is that they accept cash for a service they've performed. If the customer or individual who paid that individual the cash gets audited, the IRS will see a large cash disbursement from his or her bank account. The IRS agent will then follow that lead and ask the individual what that cash layout was for. Inevitably, the trail leads right back to the individual who failed to report that money as income.
In short, it's better to be safe than sorry. Make sure you report all of your income.
#5. Home Office Deductions
Be careful with home office deductions. Excessive or unwarranted deductions can raise red flags. In addition, large deductions in proportion to your income can raise the ire of the IRS as well.
For example, if you earned $50,000 as an accountant (operating from home), home-office related deductions totaling $30,000 will raise more than a few eyebrows. Trying to write off the value of a new bedroom set as office equipment could also draw unwanted attention.
Deduct only items that were used in the course of your business.
#6. Income Thresholds
There is nothing the individual taxpayer can do about this one, but if you earn more than $100,000 each year, your odds of being audited increase exponentially. In fact, some accountants put the odds of being audited at one in 72, compared to the one in 154 odds for people with lower incomes.
Partnership/Trust/Tax Shelter Risk
If you own shares in a limited partnership, control a trust or make any other tax shelter investments, you are more likely to be audited. While there may be no way to avoid such an audit, individuals who have a stake in such an entity should be aware that they face a higher likelihood of scrutiny. They should also take even greater care to document deductions, donations, and income.
Small Business Ownership
Small business owners are an easy target – particularly those with cash businesses. Bars, restaurants, car washes, and hair salons are exceptionally big targets, not only because they deal in so much cash, but also because there is so much temptation to under-report income and tips earned.
Incidentally, other actions that go part and parcel with business ownership may draw unwanted IRS interest too, including putting family members on the payroll and over-estimating expenses.
In short, business owners must know that they can't "push the envelope." If they want to stay in business and avoid the scrutiny of an audit, it's best to remain on the straight and narrow.
So why does the IRS seem to be cracking down more and more on individuals and small business owners these days? It's simple. According to 2016 IRS estimates, there is roughly an annual $458 billion gap between what Americans pay in taxes versus what they owe. That equates to about $2,500 per household. The Congress knows this too, and given the deficits, the United States government has run up over the past 20 years, there is enormous pressure on legislators and the IRS to collect taxes owed.
What should you do if you are audited? Be honest with the auditor and respond to all inquiries as quickly as possible. Don't be afraid to show all of your documentation. If possible, have a qualified accountant and/or tax attorney represent you.
The Bottom Line
The IRS will continue to use audits as a tool to increase collections, but that doesn't mean that you have to be among the "lucky" few to be chosen. The key to avoiding an audit is, to be honest, and document your deductions, donations, and income.