6 red flags for IRS audits

Dan Gordon, CPA

For those who are following President Biden and his proposed tax increases — none have been enacted as of this writing — there are many scenarios of how he plans to raise taxes and which taxes can and will be increased. That said, one consistent item in all the proposals is to give quite a bit more funding to the IRS for audits and enforcement.

The theory is that catching tax cheats will provide significant revenue to the government. However, for those of us who are doing things right, getting audited is a huge inconvenience and may feel like an infringement on our privacy. If the government expects to raise money through tax audits, many innocent taxpayers may get audited.

CHECKING FOR CHEATERS

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The good news is that the IRS has certain tools it uses when looking at tax returns to determine which ones have issues. When returns are filed, they’re scanned into the IRS computer system, which is designed to detect anomalies. If there is an anomaly, that creates a red flag. The IRS is more likely to eyeball your return if you claim certain tax breaks, deductions, or credit amounts that are unusually high compared to national standards.

On your 1040 individual tax return, six common red flags that may lead to an audit include:

1. Failure to report all taxable income. Over the years, the IRS has received more information from third parties — not only from W2s and 1099s, but also from flow-through entities. (To clarify, most pest control companies are set up as pass-through entities.) The computer system compares that information with the tax return. If there is a mismatch, the computer generates a tax bill.

2. Earning a lot or very little. The more you earn, the higher the chance your tax return will be audited. The majority of returns audited are from taxpayers who earn more than $500,000. The IRS has limited staff, and if there is a change on a wealthy taxpayer’s return because of an audit, the money owed will be greater. On the other end of the spectrum, taxpayers who reported no adjusted gross income also are flagged. The IRS may conduct a cost-of-living analysis to see how you were able to live on hardly any income. Again, if you are showing very little income and appearing to live way beyond your means, the chance of this type of audit occurring is much higher.

3. Relying on excessive deductions or credits. The IRS will compare the itemized deductions and credits taken with the average totals for similar taxpayers in the same income bracket. If yours is higher, the IRS may look at your numbers more carefully.

4. Filing with Schedule C. Many small pest management companies are set up as sole proprietors or single-member LLCs. These businesses are entitled to a handful of deductions that most other taxpayers cannot claim, such as home office deductions, mileage and travel expenses, and meals. IRS agents know self-employed individuals tend to claim excessive deductions, so this could raise a flag. Schedule C filers also sometimes under-report income, so the IRS looks closely at businesses that primarily operate with cash or show a loss.

5. Failure to file. Addressing high-income non-filers is now the IRS’s top strategic priority. The emphasis is on individuals who earned more than $100,000, but did not file a tax return. As previously mentioned, the IRS compares information it receives from multiple sources to see whether returns were filed.

6. Claiming a loss on a hobby. You can take a loss on a business, but you cannot claim a loss for a hobby. For a business, the reasonable expectation is to make a profit three out of every five years. If you have a hobby that is set up as a business, make sure to keep supporting documents for income and expenses. If you have multiple years of losses on your Schedule C and you have a lot of income from other sources, the IRS will look at this activity more as a hobby — particularly if you do not depend on the income to make ends meet, or you do not devote the necessary time, effort and money to maximizing your profits.

The above list is not intended to be all-inclusive, of course. It’s simply to make you more aware of certain activities that can lead to IRS audits. Also, remember that if your deductions are legitimate, by all means claim them because you are entitled to them.