3 Common IRS Audit Red Flags Explained
The IRS always gets its attention drawn to certain tax returns by a number of red flags. Some of them are minor and can be ignored, some are moderate and require a simple verification while other red flags require an audit. In this article, we look at the reasons why some income tax returns get selected for an audit. We will do so using the 3 common IRS audit red flags we selected. See below.
Hiding income, or not reporting your income
The majority of businesses are run by owners, are small, and thus, are vulnerable to several mistakes. One such mistake is underreporting business income. To do this, the business ought to hide some sales receipts and doctor their accounts in order to submit a deflated figure.
Such an act, deliberate or not, is viewed as illegal tax evasion by the IRS. Individuals too can fall into this trap. Imagine someone running a side hustle or has a side, legally registered business they don’t fully work in. Income from all these should be reported so you can pay a fair share of taxes. But some individuals may be tempted to hide it, including proceeds from virtual currency trading activities.
But how will the IRS know if you hide some income?
Well, the IRS uses information returns to match what you submit with your income tax return. Remember, they get copies of all the 1099s and W-2s you receive. So, while processing your federal return, the IRS system should be able to conclude that what you submitted matches everything that they have already received.
If there is a mismatch, the system refuses to process your tax return, resulting in further investigations.
Mixing business expenses with personal expenses.
Mixing business expenses with personal expenses can be divided into two. First, it’s the personal expenses such as household groceries and office coffee, and other small supplies. Secondly, it’s other work-related expenses such as travel and business meals that can be easily mixed with personal expenses. For example, an entrepreneur could be tempted to use a business card for personal travel and hope to deduct the expenses. This won’t stand.
Regarding supplies such as household goods, a business owner can easily make an error if they use the same business credit card to purchase household supplies. Those expenses are coming out of your company account, hence, by the book, they should be deducted. But are they really ordinary and necessary business expenses? Not at all. If the IRS catches this, you will be audited. That is why I always encourage business owners to keep separate bank accounts and credit cards for personal and business use.
Nevertheless, mixing expenses is rampant in meals and travel. Recently, I shared a video warning sole proprietors not to deduct business meals for their everyday lunch and breakfast at work. That just won’t work. Every meal and travel expense you deduct should be related to your business. It must be ordinary and necessary.
For example, you can deduct a business meal that you had while having a meeting with a client. You can also deduct travel expenses you incurred to go and attend a business conference outside your usual city or home of business.
If you want to learn more about deducting business meals, sign up for my upcoming Tax Pop-Up Class to be held on October 27, 2022, for $47. In case you read this article after the class has been held, you can order a replay video by contacting our office.
Earning more money, or too little
Your income level can also trigger an IRS audit. The IRS is not jealous of your earnings, but they know that the more you earn, the more your tax return is likely to be complex. More so, declaring extremely low income could raise the IRS’ eyebrows. They may conduct a lifestyle audit on you to ascertain how you live your life with such a low income.
Complex tax returns usually trigger an audit because it’s easy to make a mistake with them. But to avoid such mistakes, you can hire a tax professional to prepare your federal tax returns every year. You can hire me HERE.
Nevertheless, the IRS audited about 1 percent of those earning less than $200,000 in 2021. And almost 4 percent of those earning more were audited. The percentage of audited tax returns increases to 12.5 percent if you raise the threshold to $1 million.
Even if you consider business tax returns, the same pattern exists. Only 1 percent of corporations with less than $10 million in assets were audited, compared with 17.6 percent above that threshold. Once again, this is because more earnings usually are from companies and individuals with multiple streams of income and transactions, which complicates their returns. More so, IRS agents know that committing resources to a single potentially big taxpayer results in a potentially bigger revenue per audit, which works well for them.
However, this is the time to not be complacent if you are a middle-income earner, thinking you may be safe. The IRS received a revenue boost from the Treasury to the tune of $80 billion in the next ten years. This money will be used to hire more agents, tens of thousands, to ensure that all taxpayers are put under scrutiny.
Frequently Asked Questions
- What are the red flags for the IRS?
IRS red flags include submitting a tax return with too many rounded figures, hiding your income, submitting a return with very high income or too little income, as well as claiming too many deductions, among others. These all raise suspicions.
- What triggers an IRS audit?
An IRS audit is triggered when the Information Returns Processing (IRP) rejects a return for inconsistency. The rejected return is further investigated, and if the discrepancy is too big, it results in an audit, sometimes by mail or a field audit.
- How much money gets flagged by the IRS?
The IRS does not have a specific amount that it flags. But it uses a different number of combinations to have an idea of a taxpayer’s profile and in which income range they may fall. Your income profile can be estimated using the W2s you submit as well as information returns received from other third parties. If your prior year’s W2s indicated you made 100K, for example, suddenly saying you now made $500K could trigger an investigation to ascertain if you did not lie in your previous returns.
- Who is most likely to get audited by IRS?
Everybody (individuals and businesses) can get audited, that is why you should always play by the rules when submitting your tax returns.
- What are the chances of getting audited in 2022?
Well, these are high, given the ongoing PPP loan fraud investigations. The government is suddenly realizing that many taxpayers could have lied to gain COVID relief funds illegally.
