The threat of an IRS audit causes anxiety among individuals and businesses alike. An IRS audit is a review of an organization’s or individual’s accounts and financial information to ensure information is reported correctly and to verify the reported amount of tax is correct.
While a certain percentage of returns are audited regardless of any triggers, there are a number of characteristics of a tax return that may attract the attention of the IRS in a way to make that taxpayer subject to an audit. Even though enforcement efforts may be delayed during the Covid-19 pandemic, taxpayers must remember that the IRS intends to maintain its enforcement efforts during this time. Some common issues that tend to garner the IRS’s attention more often are outlined below.
1. Dealing in Cryptocurrency or Other Virtual Currency
Cryptocurrency (Bitcoin, Ethereum, etc.) and other virtual currencies are increasing in popularity, with a common feature being the absence of the same level of government control as with regular tangible currency. However, virtual currencies are treated as property for federal income tax purposes, and taxpayers must recognize any gain or loss on these transactions. The IRS has a compliance campaign focused on cryptocurrency transactions, and has increased its enforcement efforts specifically designed to curb abuses. [See 190 TM, Taxation of Cryptocurrencies; TPS ¶1410.10.]
2. Earning Substantial Income
Earning a lot of income indicates a higher potential for avoiding taxes. Individuals that earn more than $200,000 are much more likely to attract the attention of the IRS than individuals earning less than that amount. Taxpayers with higher income tend to have more investment income, which triggers increased IRS scrutiny on its own, especially regarding investments that require more complex reporting such as real estate transactions, capital gains, or employer stock options. [See 501 TM, Gross Income: Overview and Conceptual Aspects; TPS ¶1010.01.]
3. Failing to Report Income
Taxpayers often omit income from their tax returns inadvertently, especially where the taxpayer has multiple accounts, or receives multiple W-2s and/or 1099s. It is easy to forget to report interest, dividends, or gains on some accounts. The IRS receives copies of information returns filed by payers, and any discrepancy between the information received from a third party and what the taxpayer reports on the return is likely to get the attention of the IRS. [634 TM, Civil Tax Penalties; TPS ¶3830.]
4. Being Self-Employed and/or Working as an Independent Contractor
For taxpayers that carry on a trade or business as a sole proprietor or an independent contractor, are in a partnership that carries on a trade or business, or are otherwise in business for themselves (including part-time businesses), not only is it easier for income to go unreported, but also for business and personal assets to get commingled. Small businesses attract the attention of the IRS, and filing Form 1040 Schedule C as a self-employed taxpayer raises the chance for an audit. Such taxpayers should be prepared for an audit by keeping excellent records and may consider incorporating or forming a limited liability company (LLC). [See 704 TM, Disregarded Entities; TPS ¶4220.]
5. Having a Home-Based Business
Home-based businesses (including part-time businesses) are typically self-employment situations, and taxpayers often are unable to accurately track income and expenses, particularly where separate bank accounts are not maintained to avoid commingling business and personal assets. Again, filing Form 1040 Schedule C will likely draw the attention of the IRS, and such taxpayers are advised to keep meticulous records on business income and expenses. [See 704 TM, Disregarded Entities.]
6. Taking a Home Office Deduction
Taxpayers often believe that if they work at home they can automatically deduct expenses related to the business use of their home for tax purposes. The exception to the disallowance of expenses related to the use of a taxpayer’s residence for business purposes when they have a home office is subject to strict rules and the IRS will be interested to investigate if taxpayers taking this deduction are in compliance. The deduction will be disallowed for taxpayers that don’t actually use the space as an office, don’t strictly maintain the space for business use, or don’t otherwise strictly comply with the rules. Unfortunately, most taxpayers that have been working from home due to the Covid-19 pandemic won’t comply. [See 547 T.M., Home Office, Vacation Home, and Home Rental Deductions.]
7. Deducting 100% of Automobile Use
Because there are tax benefits related to using a vehicle for business purposes, including deducting mileage and operating expenses for gasoline, maintenance, depreciation, etc., accounting for business use of a vehicle is often subject to abuse. Deducting a significant portion of automobile use on a return is likely to trigger an audit, and taxpayers must have proper documentation to substantiate any deductions taken. [See 519 TM, Travel and Transportation Expenses — Deduction and Recordkeeping Requirements, IV.; TPS ¶2310.05.]
8. Claiming a Hobby as a Business
While expenses relating to the production of income or to investment activities are generally deductible, the hobby loss rules limit the deductions for activities not engaged in for profit. Taxpayers may deduct expenses that fall under §183 only to the extent of gross income from that particular activity during the tax year, so in essence, losses attributable to activities not engaged in for profit are disallowed, and the IRS lends scrutiny to these activities. Note that hobby loss deductions are subject to the 2% limit on miscellaneous itemized deductions, which are not available for tax years beginning after December 31, 2017, and before January 1, 2026. [See 548 TM, Hobby Losses; TPS ¶2450.]
9. Several Consecutive Years of Business Losses
It’s common for new businesses to operate “in the red” for a few years; however, continuous periods of expenses exceeding income will likely trigger the IRS to investigate whether all income is being reported or whether the deductions reported are valid. [See 539 TM, Net Operating Losses — Concepts and Computations; TPS ¶2410.]
10. Typographical Errors and Math Errors
While typographical errors and math errors are often inadvertent, these occurrences sometimes fuel the suspicion of the IRS regarding whether there is a deliberate attempt to evade tax. In addition, typographical errors that may appear to be careless oversights may make the IRS question whether identify theft is involved. [See 636 TM, Tax Crimes; TPS ¶3829.]
11. Using Round Numbers
Having very round numbers (e.g., $100, $5,000) frequently on a return tends to look strange and often fuels suspicion of filing false returns in an attempt to either reduce tax liability or increase a refund amount. Taxpayers should use exact numbers instead of rounding them off when possible.
12. Taking Early Withdrawals From Retirement Accounts
Taxpayers often take early withdrawals from tax-favored retirement accounts that do not meet one of the exceptions that would allow a withdrawal to be nontaxable. Such withdrawals can be subject to an additional 10% penalty and the IRS is keen to detect early withdrawals that have gone unreported. [See 370 TM, Distributions from Qualified Plans — Taxation and Qualification; TPS ¶1160.03.F.]
13. Taking a Large Number of Deductions
Excess expenses in relation to income often fuel suspicion of filing false returns in an attempt to either reduce tax liability or increase a refund amount. For example, medical expenses that amount to 80% of a taxpayer’s income are likely to warrant IRS attention.
For individual taxpayers that take itemized deductions, the IRS is aware of the potential for abusing itemized deductions in an effort to increase the benefit of itemizing over taking the standard deduction, and makes an effort to investigate the validity of the deductions, especially when medical expenses or charitable contributions are really high in proportion to the taxpayer’s income, or when the taxpayer deducts casualty losses.
The IRS may not only request substantiation of those expenses but also investigate whether the taxpayer has unreported income that’s being omitted from the return. [See 503 TM, Principles of Income Tax Deductions; TPS ¶2010.]
14. Owning a Cash-Based Business or Reporting a High Volume of Cash Transactions
Businesses that handle a lot of cash routinely (e.g., nail salons, restaurants, car washes, etc.), especially those in which workers make tips, are prone to the underreporting of income. Taxpayers reporting tips or other revenue generated from cash-based businesses are subject to intense IRS scrutiny and should be diligent in reporting their income transactions.
Reporting a high volume of cash transactions or large cash transactions also would come under scrutiny for detection of tax crimes and other potential criminal activity. Note the requirement to complete Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, for large cash transactions. [See 636 TM, Tax Crimes, I.C.; TPS ¶ 3820.05.G.2.]
15. Having Cash or Assets in Another Country
If the IRS suspects that a taxpayer possesses $10,000 or more in foreign-held assets and has not filed a Foreign Bank Account Report (FBAR), or if they believe a taxpayer misreported assets and income on the FBAR, the taxpayer may be subject to an FBAR audit. FBAR audits can be complex and the failure to comply with FBAR reporting requirements can subject the taxpayer to exorbitant penalties. [See 6085 TM, Report of Foreign Bank and Financial Accounts (FBAR); TPS ¶7170.02.B.]
16. Claiming the Earned Income Tax Credit (EITC)
Eligible individuals may claim a refundable personal credit if they have a qualifying child or satisfy three specific conditions. Claiming this credit has been subject to abuse and the IRS has increased the scrutiny on taxpayers claiming this credit and has extended its investigations into return preparers that aid taxpayers in obtaining the credit. [See 513 TM, Family and Household Transactions, III.K.; TPS ¶3830.10.B.8.]