One of the biggest fears of many of my clients is the risk of a tax audit or examination by the IRS. While the actual chances of getting audited are exceptionally low, it is the last thing one wants to go through.
If you are doing things correctly, then going through an audit is nothing to worry about. If you have done things incorrectly on a tax return either accidentally or intentionally, then you are very right to fear an IRS audit.
The good news is that IRS audits have been way down in recent years due to budget cuts. In 2019 the IRS only audited 0.4% of individual tax returns. This is about 1 in every 160 returns that gets audited. Many people view this number in different ways.
Some still see it as a chance to be audited and it keeps them not only filing a squeaky-clean tax return but it sometimes hinders people from taking advantage of some of the credits that they do qualify for in fear of an audit. Others see that as a low number and think it is worth the risk in the attempt to save some money.
In today’s article, I will not only explain what an audit is, but I will break down the audit process for you. After that, I will point out some examples of common errors that raise red flags with the IRS and put taxpayers into these audits. Hopefully, this information can help you avoid ever having to deal with this situation.
What Is an IRS Audit?
An IRS audit is a review or examination of an organization’s or individual’s accounts and financial information to ensure information is reported correctly according to the tax laws and to verify the reported amounts of tax are correct. In other words, the IRS is double-checking the information you put on your tax return.
By law, the IRS generally has 3 years after the tax filing deadline to initiate an audit. If you leave out up to 25% of your income or more, they have 6 years. The IRS performs these audits to minimize the tax gap or the difference between what the IRS is owed and what the IRS receives.
How Do Taxpayers Get Selected For An Audit?
A tax return is selected for audit by several different methods. Sometimes returns are selected based solely on a statistical formula. The IRS compares your tax returns against norms for similar returns. They develop these “norms” from audits of a statistically valid random sample of returns as part of the National Research Program the IRS conducts. The IRS uses this program to update return selection.
Another way is called related examinations. This is when your returns are selected because they involve issues or transactions with other taxpayers such as business partners or investors whose returns were selected for audit. The IRS uses a program called the Discriminant Function System. This is a computer software program that gives each tax return a score called the DIF Score. This score is a number that statistically determines the likelihood of the tax return being accurate. The higher the number assigned, the higher the chance to be audited.
If selected by either of these methods, then an experienced auditor will review the return. They may accept it and move on or if the auditor notes something questionable, they will identify the items noted and forward the exam to an examining group.
What Is the Tax Audit Process Like?
At this point, the IRS will either mail you or contact you to set up an in-person interview to review your records. The interview may be at an IRS office (office audit) or at the taxpayer’s home, place of business, or accountant’s office (field audit). Remember, you will be contacted initially by mail. The IRS will provide all contact information and instructions in the letter you will receive.
If the IRS conducts your audit by mail, the letter will request additional information about certain items shown on the tax return such as income, expenses, and itemized deductions. They will provide you with a written request for the specific documents they need to see. Basically, they are giving you the opportunity to prove you had rights to put whatever they are disagreeing with on the return.
If you can prove your side of it, then you can respond with the requested documentation.
Why Did I Get Audited?
There are some key triggers that will raise red flags with the IRS. If your tax return has any of these make sure you have the proper documentation and information to support them if the IRS disagrees with them. In this section, I will lay out and explain some of these triggers so you understand them to help you avoid a possible audit.
This is probably the easiest way to get yourself into an audit with the IRS. This can happen on accident by not receiving an income from or forgetting other incomes received other than your primary wages. This is why it is so important to keep good records of all income received throughout the year and to keep copies of all income forms received.
When these income forms, W-2’s or 1099’s are sent to you by your employers or financial institutions that you have done business with they are also sent to the IRS. So if when your return goes through the system and the incomes do not match up with what has been reported to them, this will raise major red flags.
With self-employment, there are a lot of red flags that can be triggered. With self-employment, most of the income received is reported to the IRS with a Form 1099. So, if your version of your income for the year does not match up with what is reported to the IRS then you may be dinged for underreporting of income.
Another big benefit of being self-employed is being able to write off portions of that income due to expenses. This can be a benefit and a curse. The IRS does understand that it takes money to make money, but they also understand that people don’t work hard for little or nothing. These types of returns are highly auditable especially when large portions of the income are written off.
You can be eligible for deductions from your income if you donated to charity throughout the year. If somebody puts large charitable donations this will raise the red flags especially if they have low income themselves.
Math Errors & Using Neat Round Numbers
Do not make mistakes. If you accidentally do the math wrong or put an 8 instead of a zero you can be hit with fines. Also, when inputting expenses and deductions using round numbers can trigger the IRS to request proof.
Stock Trades & Cryptocurrency Sales
All of this income must be reported. With these transactions, the brokerage or financial institution will send a Form 1099 to the IRS. Right now, cryptocurrency is a hot-button issue. With this income, it is especially important that not only is it reported but also you show on a Schedule D your gains and losses. Forgetting to report information on a 1099-B or any big change in your capital gains income could lead to an audit.
Statistics show that the more money you make the more likely you will be audited. In 2019 people earning $200,000 to $1 million had an audit rate of less than 1% while people making over $1 million had a 2.4% audit rate.
Claiming the Earned Income Credit
Claiming the EIC is an automatic trigger for an audit. The IRS will make sure that you are entitled to claim the dependents and that the income that you are reporting is correct.
How to Avoid an IRS Audit
There is good reason to fear the possibility of an audit. Despite the fact that only a small percentage of people actually get audited by the IRS, that still amounts to a large number that has to go through this process every year.
As I wrote earlier, do not let the fear of audit hinder you from taking advantage of deductions and credits that you have rights to. If you have done things right and you have the information to prove it then an audit is no problem. If you are doing things that you do not have rights to or cannot prove, then you are rolling the dice and will have to deal with the consequences if selected.
As I always recommend when filing a more complex tax return and utilizing deductions and credits, it is always well worth hiring a true tax professional. While many call themselves a tax professional, you will want to be sure the person your hire is somebody with the correct education and licensing.
Unfortunately, there are many tax preparers who may use certain strategies on your tax return to reduce your tax debt and/or maximize your refund but those strategies are also major tax audit triggers. If you hire an IRS Enrolled Agent or a CPA, both have a license and are regulated, so they have something to lose if they make a mistake. An Enrolled Agent will also put their name on the return, backing up their work.