IRS Audit Red Flags for 2021

As a business owner, I have been through two IRS audits during my career. I had heard about them, but until you have actually been through one (or two), you do not understand how much anxiety they produce or the amount of time that goes into preparation. Thankfully, in both cases, my result was “no change,” which is about the best that you can hope for. I guess I can say that I am officially an audit survivor, which means that I can attest that the 10 Red Flags that we will discuss here are not things to be trifled with. The IRS is officially doing less audits than they used to, but they have used new and improved tools to ferret out those who will be audited—that leaves them with a lot less “no change” people to sift through to collect additional tax revenue. And be advised that these are not presented in any particular order, they are all cautionary items to vigilantly watch over.

  1. Typos and Math Errors—I am mentioning this one first because it may be the most common. Reordering digits in your math or your social security numbers will be picked up by automated review, and if things do not add up, or they can’t find you via SSN, your return will be identified for further review. Check your numbers a minimum of three times, and if you use a tax preparer, check their work as well.
  2. Unreported Income—When we file taxes, we provide evidence of income in the form of W-2 and 1099 forms. The IRS also receives copies of this proof of income by the employers and companies who provide the income. Either through error, or intentional omission, some taxpayers fail to report some of this income. The IRS can easily cross-check what they receive from the taxpayer against the statements of the income provider and if they do not match, it creates an automatic red flag. If you receive a form that is incorrect, make sure you contact the issuer for correction, you do not want to be incorrectly reporting your income.
  3. Tax Filers using Schedule C—The Schedule C form is for Tax Filers who operate businesses to show income and expenses. Many businesses operate on an all cash or part-cash basis. The IRS has abundant experience in looking for businesses who understate income or overstate expenses. When filing taxes make sure that your Schedule C reflects your business records, and do not “cook the books.” Double record keeping represents a kind of fraud that will likely be uncovered with substantial consequences.
  4. High Income—Interesting fact about audits: If you earn less than $200k income, you stand about 1% chance of being audited, and the percentage grows from there. If you earn over $1m, your likelihood of an audit is over 10%. Since we are all trying to increase our income, realize that the importance of being meticulous in every aspect of reporting is high at any level of income but it grows as your income increases.
  5. Abnormally High Deductions—With all the data from all the taxpayers in the country, the IRS can track just about anything they want to. They keep averages on income, but they also keep averages on deductions. They can tell you the average deductions at any level of income, and they can also provide averages for any specific tax deduction. Make sure that you can support any deductions that you claim, that your deductions are legitimate, and that you can provide logical explanations for any deduction you take that is high compared to other items that you deduct. High deductions with low income are recipes for IRS scrutiny. Your deductions may be completely legitimate, but you may have to prove it if you are audited—make sure you can.
  6. Deduction for Home Office Use—Having a home office is not automatically a red flag, but the burden of proving that the home office space is used “regularly and exclusively” for business falls on the taxpayer. Having entertainment like television in the home office is no better than putting a desk in front of the tv in your living room or working from your dining room table. It is also challenging to claim that you have and need a home office when you are working for wages (although remote work during Covid 19 may soften this restriction a little). I mentioned my own audits at the beginning. For my first audit, I had to supply pictures of our company’s front office and consulting area because we were using our living room as our place of business—it was all we could do as a start-up business, and with my evidence, the IRS accepted the deduction.
  7. Business Use of a Vehicle—For vehicles used in business, document everything! Expenses and mileage for business plus expenses and mileage for personal use. It is highly irregular for a vehicle to be used exclusively for business, and the higher the percentage that you claim for business use, the more likely it is that the IRS will target it for additional review. And if you have only one vehicle, be very careful about how much you claim for business usage.
  8. Business Meals, Travel and Entertainment—This has been one of the most abused categories of deductions over time. Once again, documentation will be essential, not only the receipt, but who was involved, what meetings were held, what topics were discussed, etc. The IRS takes a dim view, as well, of claiming reimbursed expenses as tax deductions. If you are going to hold your annual company meetings in Hawaii, you’d better have ample documentation that the portion of the trip that was for your enjoyment is carefully partitioned from the business portion in your records, and that you only claim the legitimate business portion on your taxes.
  9. Business Loss—In the eyes of the IRS, a business is established with the intent of producing a profit. They understand that a new business will have a lot of startup expenses and a gradual build in income, so business losses during the first two years of the business are more easily understandable, and even long-standing businesses can have an off year, or extremely high capital expenses for a year. But businesses that experience repetitive losses are more likely to be identified as hobbies. I know a person who established a “business” restoring vintage automobiles for resale. His problem was that after he restored it, he would tend to fall in love with it and keep it, thus incurring expenses, but keeping all the product and producing little profit. I do not know details, but I know the IRS ultimately deemed it a hobby, and I know he had to liquidate several beloved vehicles.
  10. Earned Income Tax Credit (EITC)—Apparently, the IRS has an estimate of how many EITC claims are paid in error, and it is a multi-billion-dollar loss to them. In recent years, the IRS has tightened its review of these claims. Their studies have shown a large percentage of claims include fraud, so they are doubly interested in closing any loopholes that exist and auditing a larger number of claims. Be conscientious in following the rules closely in case you must provide proof in an audit.

The Bottom Line—The more complicated your business, investments, and life become, the more essential it is for you to have additional eyes on your records and on your tax return. We repeatedly advise you of the importance of working with tax professionals. YOU need to be working on your business, and your TAX PREPARER needs to be working on your taxes and records. They are not emotionally caught up in your business, they can advise you on what you can claim, and let you know when you are moving into a red flag area. Working with a credible and licensed tax professional is your best defense against being audited, and if you are audited, they can prepare the records and documentation and participate in the audit process. They are afforded more respect in an audit because they are professionals who have studied tax law. Doing it all yourself is like the old saying, “bringing a knife to a gun-fight.” Prepare in advance to avoid audits, and if you do end up in an IRS audit, go in well defended!

iIRS Audit Triggers for 2021 | Personal Capital

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