The thing that scares most people about doing their taxes is the fear of being audited by the IRS. Studies have shown that over 50% of people have a negative reaction to doing their taxes, and this is even if they aren’t intentionally attempting to cheat the system. Nobody wants to be audited, so the good news is that tax audits are actually pretty rare. The IRS tends to audit inconsistencies and red flags, like the business owner with $1k of sales, but travel expenses of $20k, or the individual earning $25k annually, but donating $10k. Both could be factual, and if you have the right to a legitimate deduction, you should take it, but at face value, they look ‘off’.The keys to audit-proofing your tax return are accuracy and documentation. If you’ve been truthful on your return and retained your documentation, you can rest easy knowing you’re prepared in the event of an audit.
According to a 2022 report using IRS data from Syracuse University’s Transactional Records Access Clearinghouse, only, 3.8 out of every 1,000 tax returns (0.38%) were audited by the IRS. Sometimes, the selection of a tax return for audit can be random, but the IRS may also purposely select your tax return to take a closer look at based on their algorithm to flag potentially abnormal tax returns. Abnormalities can come from a number of sources, and we’ll cover some of them later, but they can range from your tax preparer, your connection to a business partner or investor that’s being audited, credits claimed on your tax return, or missing income.
Before we get too far into the triggers of a tax audit, let’s quickly cover the types of audits or examinations the IRS conducts. Most are underreporting inquiries, and aren’t technically audits. The IRS sends about 4 million of these automated notices every year, and its purpose is to let you know that there’s a discrepancy between what you reported versus what your employer or payer reported to the IRS. The IRS receives a copy of all of the tax documents you receive (i.e. W-2s, 1099 forms, 1098 forms, etc.). This means that for most individuals, they already know how much income to expect you to report, and before a human ever looks at your return, a computer can determine if you’ve potentially underreported your income, or have a mathematical error on your tax return. In the event you are actually audited, it is most likely to be via a mail audit (these type of audits make up over ¾ of IRS examinations), but could also be via an office or field audit. If it’s an office or field audit, it’s serious, and the IRS is likely looking far beyond your tax return. They’re examining your business activity and operations, and your personal lifestyle, likely because they suspect tax evasion.
Now that we’ve gotten the basics down, let’s discuss what could trigger an audit, and most importantly, what you can do to reduce your likelihood of being audited.
COMMON AUDIT TRIGGERS
Missing income - If you fail to report all of your income, you can likely expect a notice in the mail. Since the IRS receives copies of the tax forms you received, they know to expect at least that much income on your tax return. Their automatic matching system can detect missing income, and a notice will be generated before a human ever sees the tax return.
Questionable/Excessive business expenses - For-profit businesses should be in the business of making profit. Although it’s not impossible to have expenses with little to no income, it can become suspicious since business losses can offset other taxable income at the Federal level. If the IRS sees a pattern of this, the likelihood of an audit can increase. Furthermore, the IRS can deem your business a hobby if they see that it hasn’t shown a profit in at least 3 of the 5 years you’ve operated. If the IRS makes this determination, your deductions for expenses will be limited to the amount of income you earn (to restrict you from offsetting other income sources with your business losses).
Home office deductions - this one is tricky because years ago, claiming a home office deduction was rumored to be an audit trigger. Then, that rumor died down as people began to normalize working from home. Then COVID-19 hit, and employees all over America were working from home and assumed they qualified for the home office deduction (which is incorrect). This has put the home office deduction back on high alert since it’s been mistakenly claimed by non-business owners due to temporary work from home agreements related to the pandemic.
Cash-based businesses - Historically, cash-based business (like hair salons, nail salons and laundromats), have underreported income since cash can’t easily be tracked by the IRS. There could also be concerns that potential criminal activity, like money laundering, could be at play.
Digital Asset/Virtual Currency transactions - Activity involving digital assets (like Bitcoin) are still in the beginning stages for IRS tracking purposes. Because there is the potential that some of the activity cannot be tracked by the IRS, there’s the potential for underreporting the income, which makes it more prone to triggering an audit.
Foreign financial assets - If the IRS believes you have foreign financial accounts, and may have misreported (or not reported at all) foreign financial assets, you could become subject to an audit.
Being a black taxpayer - According to a study from Stanford University’s RegLab, black taxpayers are audited at least 3x more than non-black taxpayers (which is alarming on many levels).
Earning less than $25k per year - Believe it or not, people making less than $25k have the highest audit rate. They are nearly 5.5x more likely than others. This is because they are typically eligible for earned income tax credit, and since this generates a tax refund beyond what the taxpayer may have paid in taxes, the IRS works hard to ensure the credit isn’t being claimed fraudulently by underreporting their income.
HOW TO AVOID A TAX AUDIT
Documentation is everything – business owners need good books and records – we cannot stress this enough for business owners. Bank statements are not enough to substantiate expense in the event of an audit. When explaining this to new clients, I always give this scenario: If you spend $1k in Staples, and only have a bank statement to show that you swiped your business debit card for $1k, in the event of an audit, you have no proof that you spent that money on supplies or office equipment. It is also plausible that you purchased 1 candy bar (and got $999 in cash back for your trip to the casino), or 1,000 candy bars, because you just really love candy. That’s why bank statements simply aren’t enough. Scan and save receipts to support your expenses, and make notes on things like meals and travel expenses. If you’re audited 3 years later, you won’t remember who that business meal was with, or what that 2-day flight and hotel expense was for.
Report all income - Make sure you report all of your income to the IRS, including investment income and gambling winnings.
Don’t file too early – Most tax documents aren’t required to be mailed to taxpayers until Jan 31st. Some investment documents can arrive even later. Filing too soon increases the likelihood that you’ll miss a document, and under report your income. Give it time for all of your documents to arrive, and report income based on the formal tax documents received (not last pay stubs, or statements).
Be honest – Too often, I’ve heard “how much can I write off before the IRS starts to question it?” and that’s the easiest way to land yourself in hot water. Without documentation, a deduction or credit cannot be substantiated. Do not be dishonest on your tax return thinking there is a threshold in which your dishonesty becomes material.
Seek help if needed – If you find that you are audited, seek appropriate assistance. A CPA, EA or attorney can assist in the event of an audit, and having a professional to represent you in tax matters is like having an attorney on your side in the court of law.
Do you have questions about your taxes and avoiding an audit? Consult with the experts at ASE Group today!