01The Computer Trigger
The IRS has a computer system that's specifically designed to detect anomalies in tax returns. It’s called Discriminant Information Function or DIF, and it scans every tax return received by the IRS. It looks for things like duplicate information—maybe two or more people claimed the same dependent—as well as deductions and credits that just don’t make sense.
Who’s to say that your deductions don’t make sense? DIF decides. The computer compares each return to those of other taxpayers who earned approximately the same income. Most people who earn $40,000 a year don’t give $30,000 of that money to charity, so DIF is pretty much guaranteed to throw up a flag if you claim that you did. This prompts a review by human agents.
02You Earn a Lot…Or Very Little
The IRS isn't going to waste time its time on an audit unless agents are pretty sure that the taxpayer owes additional taxes and there’s a good chance that the IRS can collect that money. This puts a focus on high income earners.
The majority of audited returns are submitted by taxpayers who earn $200,000 a year or more, and most of them had incomes of over $1 million in 2016. If nothing else, all that income results in some pretty complex tax returns, and complex tax returns are more likely to include errors.
Conversely, you stand a higher chance of being audited if you manage to wipe out all your income through the use of tax deductions. Only about 1 percent of taxpayers earning between $200,000 and $499,999 were audited in 2016, whereas 3.25 percent of those who reported no adjusted gross income found themselves under the IRS microscope.
According to IRS statistics, you’re safest if you report income in the neighborhood of $50,000 to $74,999. These taxpayers are audited the least.
03You Overlooked Income
Uncle Sam keeps a pretty close eye on all income taxpayers receive. The government accomplishes this through the forced cooperation of any entity who pays you money for just about any reason.
Tax laws abound requiring individuals and companies to report remittances to both the IRS and to the taxpayers who received the income. Your employer must issue a W-2 for your earnings and submit a copy to the IRS as well. Independent contractors and freelancers receive Forms 1099-MISC, typically when they’re paid more than $600 for services. The IRS gets copies. If you have interest or dividend income, you can expect a Form 1099-INT or 1099-DIV at the end of the year…and, yes, the IRS gets a copy of these, too. You can even expect that you and the IRS will receive a Form W-2G if you win at the casino or hit the lottery.
DIF knows all about these information forms received by the IRS, so up goes the flag if your tax return fails to include any of them. Keep careful track of all income you receive and be sure to report it. And you might want to keep track of income that does not result in an information return, too, such as tips, cash you were paid for services, income that falls under that $600 1099-MISC limit, or alimony you may have received. With very few exceptions, all income you receive is taxable and must be reported.
04You Spent or Deposited a Lot of Cash
Various types of businesses are required to notify the IRS whenever anyone engages in large cash transactions, typically involving $10,000 or more. If you plunk down a lot of cash for any reason, you can expect the IRS to wonder where that money came from, particularly if your reported income doesn’t support it.
Maybe your teenager has been saving for years and years to buy his first car. He empties out his savings account and hands over $10,000 to purchase his new wheels. If he buys from a dealership rather than a private party, the IRS will be notified. If he files a tax return, he should be prepared to show the IRS how he accumulated that money. He might hear from the IRS even if he doesn't have to file a return—if his income is that minimal, it really waves a red flag.
Reporting rules for banking and financial institutions impose time limits as well. A $9,999 deposit on Monday might not have to be reported…unless you deposit an additional $1 on Tuesday.
05You Claim a Lot of Deductions
The IRS expects that taxpayers live within their means. They earn, they pay their bills, and maybe they’re lucky enough to save and invest a little money as well. It can trigger an audit if the equation isn’t equal or reasonable and you’re claiming tax deductions for a significant portion of your income.
This trigger typically comes into play when taxpayers itemize, such as in the example of donating $30,000 of your $40,000 income to qualified charities. Mother Theresa might have gotten away with it, but it’s just not a realistic scenario for most individuals. Likewise, it will probably prompt questions if you claim that you spent a great deal on mortgage interest when you just don’t earn enough based on your reported income to qualify for such a large mortgage.
If you earn between $50,000 and $100,000 a year, the IRS figures that you probably won’t make charitable contributions in excess of about $3,100 or pay mortgage interest in excess of about $7,500 a year.
06You Dipped Into Your Retirement Funds
Maybe you’re not quite near retirement age yet but something has happened that requires you to dip into the money you’ve been investing in a 401(k) or IRA. This, too, can trigger an audit—not because it’s considered tax fraud to take early withdrawals, but because many people who do so also make mistakes on their tax returns. The IRS reports that a walloping 40 percent of those taking early withdrawals in 2015 also goofed when they reported the event on their tax returns. Where there are mistakes, there’s likely to be additional tax revenue for the IRS.
Most of these mistakes relate to taxpayers not paying the corresponding tax penalty for early withdrawals. The magic number is age 59 1/2. If you’re older than this, withdrawals are typically no big deal, although in many cases you will have to pay income tax on the distributions. If you’re younger, however, you’ll also have to pay a 10 percent tax penalty on the withdrawal. There are exceptions to this penalty, but don’t claim one of them unless you’re very sure you qualify. The IRS says that this is where most people make mistakes and open themselves up to an audit.
Sole proprietors and freelancers are entitled to a host of tax deductions that most other taxpayers don’t get to share, such as home office deductions, mileage deductions, and deductions for meals, travel, and entertainment. These expenses are tallied up on Schedule C and deducted from your revenues to determine your taxable income.
DIF is on the lookout for deductions that are above the norm for various professions. It might be expected that you would spend 15 percent or so of your income on travel each year if you're an art dealer because that's about what other art dealers spend. If you claim a 30 percent, you can probably expect the IRS to take a closer look at your return.
Likewise, if you use your car for business purposes and you want to deduct your expenses or mileage, the IRS doesn’t want to hear that 100 percent of your travel was solely for business purposes, especially if you have no other vehicle available for personal use. Presumably, you drove to do personal errands at some point. And the IRS knows that taxpayers who claim home office deductions often get the rules wrong, so there are potentially some additional tax dollars there as well.
08You Own a Cash Business
If you operate a mostly cash business—no one is issuing you 1099s for your services but rather they’re handing over $50 for that haircut—this can put you on the IRS radar as well.
Businesses that fall into this category include salons, restaurants, bars, car washes, and taxi services, according to the IRS. Perhaps unfairly, it takes the position that it's particularly easy for the owners of cash businesses to stuff that $50 into their pockets and forget about it at tax time. A flag will go up if your lifestyle is such that your reported income just can't pay all your bills.
How would the IRS know about your lifestyle? There are all those deductions you're claiming, of course, but the IRS also takes tips from concerned citizens. So if you've made a few enemies and you're driving around in a Ferrari while you're reporting income of $50,000 on your tax return, the IRS might find out about it.
09You Claim Your Hobby as a Business
Maybe you breed puppies and sell them. Does this mean you’re self-employed? Possibly, but a whole lot of tax rules determine a distinction between a business and a hobby.
If you're self-employed, you get all those neat Schedule C tax deductions. If your enterprise is a hobby, you can only deduct expenses up to the amount of income you received from your endeavor. So if you sell five puppies for $500 each, the most you can deduct is $2,500 in related costs, and even then only if you itemize. You can’t use a loss to offset other income. It's obviously more advantageous tax-wise to call your hobby a business, and the IRS is aware of this. Thus, all those tax rules.
Your hobby is not a business if you haven’t shown a net profit from it in at least three of the last five tax years. An exception exists if you’re breeding horses—in this case, it’s two out of seven years. If you're just starting out and this is your first year at your enterprise, you can file Form 5213 to give yourself four more years to generate that profit, but this can trigger a closer look by the IRS, too.
The IRS probably won’t consider your enterprise a business if you don’t depend on the income to make ends meet or devote the necessary time, effort and money to maximizing your profits. In other words, you really work at it and for a significant amount of time each day. You'll need records to prove that if you're audited.
10You Have Assets or Cash in Another Country
This is a big one. The IRS is particularly interested in taxpayers who have assets and cash stashed in other countries, particularly in those with more favorable tax laws than here in the U.S. Yes, the IRS can usually access your account information from a foreign bank, and it will do so if it feels that you may owe taxes on the money you've placed there.
You’re obligated to report all foreign accounts with total, cumulative balances of more than $10,000 on FinCEN Form 114. You'll comply with tax law if you do so, but you might also expect the IRS to check and make sure that your account balances really are what you’ve claimed them to be.
Top 10 Tax Audit Triggers
The IRS Watches for Certain Things
Studies have shown that sitting down to prepare a tax return can actually raise some people’s blood pressure, and it’s not the unpleasantness of having to crunch numbers that causes the spike. It’s fear of making a mistake that will incur the wrath of the Internal Revenue Service and plunge them into the nightmare of an audit.
But full-blown audits don't actually happen all that often. The IRS is auditing fewer returns these days, mostly due to federal budget cuts that have affected staff size since 2010. Only 0.6 percent of returns earned extra, intense review in 2016. This was down from about 0.8 in 2014 and 2015. That said, there are a few mistakes that taxpayers commonly make to increase their chances of falling into that small percentage.