Red Flags for IRS

Certain red flags in a tax return are sure to draw scrutiny by the IRS. Some are easy to sidestep. Others, can't be helped.

The Internal Revenue Service uses a combination of automated and human processes when selecting which tax returns to audit. All tax returns are compared with statistical norms, and those with anomalies undergo three layers of review by personnel.

Audits then occur either by mail or in meetings at taxpayers’ places of business. They can be unpleasant and are sometimes unavoidable. Donald Duncan, founder of Chicago-based D3 Financial Counselors, says certain red flags are sure to draw scrutiny. Some are easy to sidestep—unreported income, for example. Others, such as high income, can’t be helped.

Not reporting all of your income

Unreported income is perhaps the easiest-to-avoid red flag and, by the same token, the easiest to overlook. Any institution that distributes an individual’s income will report it to the IRS, and the more income sources you have, the greater the difficulty in keeping track.

Old brokerage accounts are commonly overlooked, as are Form 1099s, Duncan says. One of Duncan’s recent clients took a distribution from a college savings account to pay tuition, exactly as he was supposed to do with those funds. But he forgot to tell the IRS, which had received notification from the institution. “The IRS matches all reportable items to a person’s return,” Duncan says. “If they don’t see it they will automatically conduct at least a letter audit.”

Breaking the rules on foreign accounts

The Foreign Account Tax Compliance Act has strict reporting requirements for foreign bank accounts. The law requires overseas banks to identify American asset holders and provide information to the IRS. Individuals must report foreign assets worth at least $50,000 on the new Form 8938.

“It used to be you didn’t have to report it; you just had to check a box that you had one,” Duncan says. “Now you have to not only check the box, you have to identify the institution and the highest dollar amount the account was at the previous year.”

The regulations demand openness, which in turn increases the likelihood of an audit. That’s because of a “perception that people with foreign accounts are trying to hide something,” Duncan says. But it’s a Catch-22: Compliance with the law increases the likelihood of an audit, and noncompliance can result in stiff penalties and significant legal liabilities.

Blurring the lines on business expenses

The IRS will give a close look to excessive business tax deductions. The agency uses occupational codes to measure typical amounts of travel by profession, and a tax return showing 20% or more above the norm might get a second look, Duncan says. Also, take-home vehicles aren’t considered strictly business, so a specific purpose should accompany any vehicle-related deduction.

Generally speaking, the IRS can be picky about mixing business and personal expenses. Meals and entertainment can be allowable, but exceeding the occupational norm by a great amount invites an audit. “Meals and entertainment oftentimes can be a blurred line, and the IRS doesn’t like any blurred lines,” Duncan says.

Earning more than $200,000

Last year the IRS audited about 1% of those earning less than $200,000, and almost 4% of those earning more, according IRS data. Raise the threshold to $1 million and the percentage of audited tax returns increases to 12.5%.

The same patterns exist when it comes to business tax returns: 1% of corporations with less than $10 million in assets, compared with 17.6% above that threshold. Duncan says the IRS isn’t arbitrarily picking on high earners. "The IRS is applying the rule of big numbers,"

Duncan says. "If people make more money, there is a better likelihood of a higher claim."

For one thing, higher incomes are likely to result in more complex tax returns that are more likely to contain audit triggers. More importantly, the IRS wants to maximize return on investment, something the agency gets better at every year: $55.2 billion was collected through enforcement activities last year, a 63.8% increase since 2001 without adjusting for inflation. But enforcement personnel increased only 9.8% during that time.

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