By Kevin Theissen
Certain red flags could increase your chances of getting the attention of the IRS. Luckily, the chances that your tax return will be chosen for an audit are very low. The IRS audited less than 0.5% of all tax returns in 2019. The majority of exams were by mail, which means that most taxpayers never met with an IRS agent in person. Also, it is likely that the IRS audit rate will be even lower for 2020 because of Covid. This doesn’t mean you should try to avoid paying what you owe but the following red flags could increase your chances of receiving an IRS letter.
Higher income taxpayers
The chances go up as your income increases. Taxpayers with incomes between $250,000 and $1 million had close to a 1% chance of audit. And about 2.5% of taxpayers’ returns reporting incomes of $1 million or more were audited.
Failing to file
The primary focus of the IRS seems to be on individuals who received more than $100,000 of income but failed to file a tax return – but this is a red flag for any level of taxpayer. Non-filing could result in levies, liens or criminal charges.
The IRS has new focus on taxpayers who sell, receive, trade bitcoin or other virtual currencies. They recently went to federal court to get names of customers of Coinbase, a virtual currency exchange. Know that all individual taxpayers must state on their 1040 if they received, sold, sent, acquired or exchanged virtual currency last year. The tax rules treat bitcoin and other cryptocurrencies as property for tax purposes.
Taking large charitable deductions
The IRS knows the average charitable donation for certain income levels. Keep all your documents, including receipts for cash and property contributions made during the year.
Not reporting income
The IRS gets copies of all the 1099s and W-2s you receive, so you need to report all required income on your return. A mismatch sends up a red flag and causes the IRS computers to spit out a bill. Report all income sources on your 1040 return, whether or not you receive a form such as a 1099.
Owning a business
A Schedule C is the place for tax deductions for self-employed people. The IRS knows that self-employed people often claim excessive deductions and fail to report all their income. Sole proprietors reporting at least $100,000 of receipts on Schedule C and cash heavy businesses have a higher audit risk. The same is true for business owners who report significant losses.
Multiple years of business losses
If you report several years of losses on Schedule C, and the business looks more like a hobby, this is a red flag. This is especially true if you have higher income from other sources. You need to have a reasonable expectation of making a profit and show a profit 3 out of every 5 years.
Business use of a vehicle
When a car is depreciated, it has to be a percentage of its use during the year that was for business. Claiming 100% business use of an automobile is a big red flag. It’s important to keep detailed mileage reports. Also, keep in mind that if you use the standard mileage rate, you cannot claim expenses for maintenance and insurance. This would be another red flag.
Unreported IRA and 401k distributions
Traditional IRAs and 401(k) distributions are often taxable income. Also, if you take a payout before 59½ years old, you are, more often than not, subject to a 10% penalty on top of the regular income tax. A 2015 IRS report found that nearly 40% of individuals investigated made errors on their income tax returns with respect to retirement payouts, with most of the errors from those who didn’t qualify for an exception to the 10% additional tax on early distributions.
Failing to report gambling winnings or claiming big gambling losses
Gambling winnings must be reported as income on your tax return. Professional gamblers show their winnings on Schedule C. It’s important to report gambling winnings because casinos and other sites report the amounts on Form W-2G. You can deduct losses but only to the extent that you report gambling winnings.
There are many other potential red flags out there so make sure you pay all the tax you owe but not a penny more.
Kevin Theissen is the owner of HWC Financial in Ludlow.