Common IRS Audit Triggers
February 7, 2023
REPORT: Cryptocurrency: From the IRS to the SEC & Beyond
TOPIC: Net Operating Losses
PAGE: 2023 Tax Calendar
PAGE: Quick Tax Reference Guide
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The IRS receives and processes most tax returns without further examination. However, there are a variety of factors that may attract their attention in a way that would make the return more likely to be audited through a correspondence exam or assigned to an auditor for further inquiry.
Generally, the IRS must audit a return within three years of its filing, but there are some situations in which the IRS can audit a return after that time period. Listed below are some of the more common features or characteristics of a return that may make it more likely to be selected for an audit.
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1. Digital asset transactions
Transactions involving digital assets such as Bitcoin, non-fungible tokens, and others continue to be a hot topic for the IRS. There have been billions of dollars in unreported income annually from digital asset transactions.
Although the agency has issued limited guidance in this area, Form 1040 now includes a question asking whether you have engaged in a transaction involving these assets. If you answer yes, be prepared to substantiate all transaction information. Reports have indicated that the IRS has increased their enforcement efforts in tracking digital assets transactions by using data analytics and artificial intelligence. [See 190 T.M., Taxation of Cryptocurrencies; TPS ¶1410; Digital Asset Filing Guide for 2022 Tax Year.]
2. Covid-19-related withdrawals from retirement accounts
If you took advantage of the penalty-free coronavirus-related early withdrawals from retirement plans, you must pay income taxes on these distributions or repay those amounts to an eligible retirement plan within three years of withdrawal.
So, like any early withdrawal, the IRS is keen to ensure you are reporting and paying tax on retirement plan distributions. [See 370 TM, Distributions from Qualified Plans – Taxation and Qualification; TPS ¶5550]
3. IRS matching program
Failing to report all your income is one of the easiest ways to increase your odds of getting audited. The IRS receives a copy of the tax forms you receive, including Forms 1099, W-2, K-1, and others and compares those amounts with the amounts you include on your tax return. If they are not the same, there is a good chance you’ll be audited.
So, whether you’re paid as an employee or independent contractor, keep track of the forms you receive and report all of your income. [See 643 T.M., Information Reporting to U.S. Persons – Payments Subject to Back-up Withholding; TPS ¶3820]
4. Profit or loss from business
It is easier for income to go unreported and business and personal assets to get comingled when you carry on a business. Therefore, don’t abuse the deduction for meals, entertainment, and mileage expenses by claiming excessive amounts or failing to allocate your personal and business expenses separately.
You should keep excellent books and records to substantiate your expenses and business use (e.g., mileage logs or phone app). [See 519 T.M., Travel, Transportation, Entertainment, Meal, and Gift Expenses; TPS ¶2320]
5. Gig work and side hustles
You must report gross income earned from working a side hustle, like driving a car for Uber or selling items on Etsy. This income must be reported regardless of whether you receive a Form 1099. So, you may have to make estimated tax payments, including paying self-employment taxes. [See 399 T.M., Employee Benefits for the Contingent Workforce; TPS ¶5430]
6. Home office deduction
Working at home does not automatically mean you can deduct expenses related to your home office and related expenses, like utilities. Eligibility for the so-called “home office deduction” is generally limited to self-employed individuals and small businesses. Even then, the deduction will be disallowed if you 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.
If you are claiming the home office deduction, the IRS may ask you to prove your expenses. [See 547 T.M., Home Office, Vacation Home, and Home Rental Deductions; TPS ¶2460]
7. Claiming a hobby as a business
Writing off expenses for a business is allowable but writing off expenses for a hobby is not. Generally, if you have not shown a profit from your business in at least three out of five years that you operate your business, then the IRS will view your business as a hobby. If so, then you are limited in the amount of your deductions for expenses relating to activities not engaged in for profit.
If you are operating a business, treat it that way and ensure you keep proper books and records. [See 548 T.M., Hobby Losses; TPS ¶2450]
8. Cash-based businesses
Businesses that handle a lot of cash routinely (e.g., nail salons, restaurants, car washes, etc.) are subject to the underreporting of income, and even more so in situations where workers make tips. Taxpayers reporting tips or other revenue generated from cash-based businesses may be subject to IRS scrutiny and should be diligent in keeping meticulous records and reporting their income transactions.
Reporting a high volume of cash transactions or large cash transactions also may 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 T.M., Tax Crimes; TPS ¶3820]
9. Financial assets outside the U.S.
If the IRS suspects that you have $10,000 or more in one or more foreign financial accounts and have not filed a Foreign Bank Account Report (FBAR), or if they believe you misreported assets and income on the FBAR, you may be subject to audit.
An FBAR audit can be complex and the failure to comply with FBAR reporting requirements may subject you to civil penalties and criminal prosecution exposure. [See 6085 T.M., Report of Foreign Bank and Financial Accounts (FBAR); TPS ¶7170]
10. Abusive tax shelters
The IRS continuously conducts investigations to identify and stop taxpayers who engage in abusive tax scheme transactions. More recently, questionable transactions identified by the IRS include abusive syndicated conservation easements, abusive micro-captive insurance company arrangements, and abusive use of charitable remainder annuity trusts.
You may want to revisit positions you have taken on a past tax return with respect to questionable types of transactions or avoid entering into these types of transactions in the first instance. The IRS eventually tracks down the participants and their tax returns and imposes steep penalties. [See 648 T.M., Reportable Transactions; TPS ¶3835]