What Are Your Chances of Being Audited? Part III – Red Flags

Originally published in the Cedar Street Times

June 13, 2014

Four weeks ago I discussed some of the statistics regarding your chances of being audited by the IRS, and two weeks ago I discussed audit selection methodology.  A few of the high points from the articles were: 1) on the average, audit rates for individuals are generally less than one percent each year, and increase as you make more money, 2) about 75 percent of audits are actually mail correspondence audits focused on a narrow request of information for specific items on your return rather than a full-blown in-person, field audit, 3) the IRS does not release its exact methods of selecting audits, and many people have incorrect notions about this process, 4) the IRS does tell us audit selection is aided by a computer scoring system to help find returns that will likely yield a change; it uses computer matching to ensure information reported on 1099s by third parties matches what you report; it uses publicly available information; and it uses statistical random sampling.  The rest of this article will be devoted to “red flags.”

So what are these “red flags” everyone talks about?  One fairly obvious assumption we can make from the audit statistics released by the IRS is that they follow the money!  You are three times more likely to be audited if you make over $200,000 a year and over eleven times more likely to be audited if you make over $1,000,000 a year.  C-corporations face a similar dynamic of increasing audit rates on larger corporations – for instance, one out of every three corporations with assets over $250 million are audited.

Not reporting all your income even when it is reported to the IRS should not be a surprising red flag, but it happens frequently.  I see this most commonly with stock sales reported on a 1099-B when people prepare their own returns – they either forget, or do not understand the form.  I also see this with contract work where a 1099-Misc is issued and the individual forgets to report it.

There are a number of issues related to small businesses that raise eyebrows.  Keep this in mind – anytime there is an easy path for someone to pass-off personal expenses as business expenses, you are going to have a higher level of scrutiny.  For instance – relatively high amounts of: business automobile mileage (or claiming 100% business use on your vehicle – very rare in reality), home office deductions, meals and entertainment, or travel expenses.  All of these can be easily abused, so they are highly scrutinized.  If you are beyond the norms, you are a clearer target.

Here is another golden nugget – if your job is one that millions of people do for fun as a hobby (although perhaps not nearly as well!), then you have a higher level of audit risk, particularly if you are losing money.  Think of the arts – photography, video, music, drawing, painting, performing, etc.  Also, think of horse racing and breeding for the wealthier set.

That brings us to another “red flag,” businesses that lose money every year.  The IRS is trying to determine which of these three describes your nonprofitable business situation: 1) Are you really trying to make this successful and genuinely feel it will be profitable overall?  2)  Are you trying to deduct your personal expenses, your hobby, or keep up appearances? or 3) Are you just plain nuts?  By allowing people to continue businesses circumscribed in two and three, the rest of the country is having to foot the bill for the lost tax revenues.  This is because the “losses” generated are offsetting the person’s other income that would otherwise be taxable.  With no realistic future expectation to recuperate the losses, the IRS is ready to pounce.

Claiming rental losses in California is fairly common due to the high cost of our real estate, but claiming a real estate professional designation in combination with these losses is an area of greater concern.  If your main occupation is in the real estate related field, and you work at least 750 hours in this trade, you are allowed to deduct all of your rental losses in the year they are incurred.  Everyone else get to deduct $25,000 at most, and are rapidly phased out to no deductions for the losses based on income levels.  The losses get suspended until the property is disposed of or until there is passive gain to offset.  There are a lot of challenges when it appears the person has substantial earned income from a trade or business unrelated to real estate or if there is very little income from real estate related trades.

Refundable tax credits such as the Earned Income Tax Credit, Child Tax Credit, American Opportunity Credit (for education), and Health Care Tax Credit can also be a point of concern, particularly when the total refund on your return is higher than the tax paid in to the system!  The IRS receives thousand of fraudulent returns each year that use refundable credits to steal money from the government.

Although harder to catch, unreported foreign income is an area worth mentioning due to the extremely high penalties by the Treasury Department for failure to report foreign accounts, and it has been a hot-button issue that has raised billions in revenues.

The above is not an exhaustive list, but it does describe many commonly seen areas of concern.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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