1. High-income earners who owe back taxes
Applying funding provided by the Inflation Reduction Act, the IRS created the High Wealth, High Balance Due Taxpayer Field Initiative allowing the IRS to prioritize high-end collection efforts for taxpayers with total income above $1 million and owe more than $250,000 in recognized tax debt. The IRS has now collected more than $482 million in an ongoing effort to recoup taxes owed by 1,600 millionaires.
2. Partnerships and other pass-through entities
Large partnerships and other pass-through entities are now increasingly subject to examination thanks to new tools such as AI and data science experts to help identify potential compliance risks for a taxpayer segment that historically has been subject to limited audit coverage. In support of such efforts, the IRS launched the Large Partnership Compliance Program examining some of the largest and most complex partnership returns covering a cross-section of industries such as hedge funds, real estate investment partnerships, publicly traded partnerships, and large law firms. These partnerships on average each have more than $10 billion in assets.
The IRS also has identified partnerships with over $10 million in assets whose balance sheets are showing large discrepancies in the millions of dollars between end-of-year balances compared to beginning balances the following year.
If you participate in one of these entities, the IRS will first audit the entity and any adjustments will then flow through to your personal return.
3. Digital asset transactions
Transactions involving virtual currencies, digital assets, and non-fungible tokens continue to be a major area of emphasis for the IRS after reviews of records from digital currency exchanges obtained through John Doe summons efforts showed the potential for a 75% non-compliance rate among taxpayers.
Form 1040 includes a specific question asking whether you have engaged in a transaction involving these types of assets. If you answer yes, be prepared to substantiate all transaction information. In addition, digital asset transactions will eventually become part of the Form 1099 reporting regime by brokers and others and will need to be reported on the return. [See 190 T.M., Taxation of Cryptocurrencies; TPS ¶1410; Guide for Digital Asset Reporting]
4. Form I099 and other document matching programs
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, Schedule K-1, and others and compares those amounts with the amounts you report on your tax return. If they are not the same, you will almost certainly receive a notification from the IRS that your reported income and tax are incorrect. So, whether you are paid as an employee or independent contractor, keep track of the forms you receive and report all your income and expenses. [See 643 T.M., Information Reporting to U.S. Persons – Payments Subject to Back-up Withholding; TPS ¶3820]
5. Profit or loss from business (Schedule C)
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]
6. Employer Retention Credit Claims
The IRS has announced a series of steps to curtail many abuses surrounding the Employer Retention Credit, whereby employers can get refunds of employment taxes for having kept employees on their payrolls during COVID. To give taxpayers an opportunity to undo questionable claims, the IRS has established a process for withdrawing an ERC claim that has not yet been paid and a voluntary disclosure program for those who are ineligible and want to repay refunds already received.
7. 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. 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]
8. 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 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]
9. 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]
10. 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]
11. Financial accounts and 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 FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), or if they believe you reported incorrectly or have misreported values on the FBAR, you may be subject to audit. The IRS routinely seeks banking and account information from both domestic and overseas institutions. IRS analysis of multi-year filing patterns has identified hundreds of possible FBAR non-filers with account balances that average over $1.4 million. The IRS plans to audit the most egregious potential non-filer FBAR cases in Fiscal Year 2024.
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]