7 IRS Audit Red Flags you Should be Aware of
This is a guest post by 20SomethingFinance reader and frequent commenter, Natalie H. Natalie is a tax preparer, so her advice here is very insightful and helpful. Her passion for answering income tax related questions is very evident in her comments – in fact, she doesn’t even have a website to link back to with her efforts here, she did it because she loves this stuff. Although many of us have filed taxes already, this post has lessons that should be heeded year round. Thanks for the great post, Natalie!
Even the mention of an IRS audit makes most people cringe. Last year the IRS audited under 1% of individual returns. That may not seem like much, but there are some individual profiles and situations that are much more likely to be audited than others. Here are seven situations that may increase your chances for an audit.
1. You work in a cash industry:
If you are a tip earner and/or get a significant portion of your income in cash, you may be more likely to be audited. If you work in a cash industry, keep a tip/cash journal. This could save you if there is a dispute.
2. You claim a loss on a schedule C:
The IRS Schedule C form (profit or loss from a business) is used not only by sole proprietors, but also by by independent contractors or other workers who get a 1099-misc instead of, or in addition to a w2 at the end of the year. Although the IRS understands it is normal to have a loss on a schedule C, especially for the first year or two of a new business, they may question losses. This is especially so if this loss offsets wages earned by the same taxpayer and qualifies them for an earned income credit.
3. Your income and expenses are unusual for your neighborhood:
This is a new one since the IRS switched to its computer audit system. It compares your income to those of your neighbors and decides if yours is unusual. The system is more complex than stated here, but basically if you live in a neighborhood where the average income is $150k and you claimed $30k, the IRS’s computer may raise a metaphorical eyebrow. (G.E. note: this is a bit creepy, but it makes sense)
4. Your return is sloppy, inaccurate, or late:
If your return is handwritten, contains mathematical errors, or does not match the information supplied to the IRS on official reporting forms, you may be at an increased risk of an audit. Although a mathematical error in itself is not a big issue, the IRS may decide that your return is likely to contain more errors and decide it is worth a second look.
5. You have a high income:
According to Businessweek, in 2010 individuals earning less than 200k had a 1% chance of audit. However, those earning between $200,000 and $1 million had a 2.7% chance, over $1 million an 8.4% chance, and over $10 million a 14.2% chance . This is because the IRS is more likely to audit returns that it thinks will result in a net revenue for the IRS. Higher incomes mean small changes add up to large amounts.
6. You claim Earned Income Credit:
Earned income credit (EIC) is for low income taxpayers, especially those with children. It can be several thousand dollars if you are earning near the poverty line and have 2 or three kids. This is the IRS’s target audience at the moment. It is unfortunate but true that those the most in need are also the target of the most scrutiny. This is because the largest credit also attracts the most amount of tax fraud. The IRS estimates that 25% of people claiming EIC should not get the credit. I have seen this many times personally, so I don’t think they are far from the mark.
7. You are unlucky:
Although most audits are conducted because something on the return was suspicious, the IRS continues to conduct random audits just to keep us on our toes.
Final Thoughts on Getting Audited:
Although an audit can sound scary, the best way to combat an audit is by keeping good records and filing an accurate return. The IRS is usually lenient about penalties for honest mistakes if you can show a good reason why you thought your return to be accurate.
Also keep in mind that many audits start as a simple question about a particular item. If you have the documents to support your return, they may stop there, but if you cannot support your claim, they will keep asking questions.
Make sure to keep your return and all supporting documents for three years from the tax filing deadline or when you filed your return if you filed late. After that, the statute of limitations has passed for all but the most extenuating of circumstances and the IRS will not bother you. With the 2011 tax deadline falling on April 18, 2010 tax return and supporting documents should be kept until April 18th 2014 if you filed on time.
Have you ever been audited? Share your experience!