What triggers a IRS audit?

The IRS has a computer system designed to flag abnormal tax returns. Make sure you report all of your income to the IRS, including investment income or gambling earnings. Cash businesses, large amounts of foreign assets, and large cash deposits are some of the things that can trigger an IRS audit.

thebalancemoney.com - IRS Audit Triggers - The Balance

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Preparing a tax return can be stressful. But if you're honest and thorough when filling out your tax returns, you can take heart, because tax audits don't happen to many people. The IRS has audited fewer returns since 2010 due to federal budget cuts that have affected staff size. According to a 2022 GAO report, only 0.25% of all individual returns were audited in 2019, down from 0.9% in 2010. That said, taxpayers commonly make a few mistakes that increase the chance that an agent will take a second look at their returns. Key Takeaways The IRS has a computer system designed to flag abnormal tax returns. Make sure you report all of your income to the IRS, including investment income or gambling earnings. Cash businesses, large amounts of foreign assets, and large cash deposits are some of the things that can trigger an IRS audit.

IRS Computer System

The IRS has a computer system called the Discriminant Information Function (DIF) that's specifically designed to detect anomalies in tax returns. It scans every tax return the IRS receives. It's looking for things like duplicate information—maybe two or more people claimed the same dependent—as well as deductions and credits that don't make sense for the tax filer. The computer compares each return to those of other taxpayers who earned approximately the same income. For example, most people who earn $40,000 a year don’t give $30,000 of that money to charity and claim a deduction for it, so your tax return is more likely to be flagged by the DIF system. Note If your tax return is flagged by the IRS's computer system, a human agent will need to review your return.

How Income Affects Audits

The IRS isn't going to waste its time on an audit unless agents are reasonably sure that the taxpayer owes additional taxes and there’s a good chance that the IRS can collect that money. This puts a focus on high-income earners. According to the IRS Data Book, the majority of audited returns in 2019 were for taxpayers who earned $500,000 a year or more, and most of them had incomes of over $1 million. Additionally, the only income ranges that were subject to more than a 1% chance of an audit were $5,000,000 and over. According to IRS statistics, you’re safest if you report income in the neighborhood of $25,000 to less than $500,000. These taxpayers were audited the least in 2019.

Reporting Your Income

Your employer must issue a W-2 for your earnings and submit a copy to the IRS as well. Tax law also requires anyone who pays an independent contractor or freelancer $600 or more in a year to file Form 1099 returns with the IRS. You can expect a Form 1099-INT or 1099-DIV at the end of the year if you have interest or dividend income. The IRS will also get a copy. You and the IRS will also receive tax forms if you win a lot of money at a casino or through the lottery. All these information forms are fed into DIF, so you'll want to make sure your tax return includes all of this information. Note Most income you receive is taxable and must be reported, including tips, work you were paid for in cash, or freelance income that falls under the $600 threshold and doesn't have to be reported on a Form 1099-MISC. Even if it isn't reported to the IRS by someone else, you're still supposed to pay taxes on it.

Large Cash Deposits

Under the Bank Secrecy Act, various types of businesses are required to notify the IRS and other federal agencies whenever anyone engages in large cash transactions that involve more than $10,000. The idea is to thwart illegal activities. A side effect is that you can expect the IRS to wonder where that money came from if you plunk down or deposit a lot of cash for some reason, particularly if your reported income doesn’t support it. The IRS will be notified if you make a large deposit over the $10,000 amount. You should be prepared to show how and why you received that money if you file a tax return.

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It doesn't necessarily have to be a lump-sum deposit. The IRS says you're "structuring" your deposit if you make two or more transactions that are less than $1,000 individually but that add up to more than the threshold. Banks are required to report deposits that are for amounts less than the threshold if they might indicate illegal activity.

Claiming Too Many Itemized Deductions

You may trigger an audit if you're spending and claiming tax deductions for a significantly larger amount of money than most people in your financial situation do. If you're making a charitable donation, you may need to have the item appraised, getting a receipt, and submit Form 8283 with your tax return. Appraisals are required for donations valued at more than $5,000, and for some clothing and certain household items as well.

You're Self-Employed

Sole proprietors and freelancers are entitled to a host of tax deductions that most other taxpayers don’t get to share, such as home office deductions, mileage deductions, and deductions for meals, travel, and entertainment. These expenses are tallied up on Schedule C and are deducted from your earnings to determine your taxable income from your business. Deductions that are above the norm for your profession can trigger an audit. For example, if people in your line of work typically spend 15% of their pre-tax income on business travel each year, but you claim you spend 30% of your pre-tax income on business travel, the DIF system may flag your tax return for review. Don't stretch the truth when filling out your tax returns. If you use your personal car for business and you want to deduct your expenses or mileage, don't say that 100% of your travel was solely for business purposes if you have no other vehicle available for personal use. You presumably drove to do personal errands at some point.

Your Business Is Home-Based

If you claim a home office deduction, you may be scrutinized more than other taxpayers. You must use your home office area only for business. You and your family members should not do anything else in that space. Review IRS Publication 587 if you're planning to claim a deduction for a home office.

You Own a Cash Business

Operating a mostly cash business can put you on the IRS's radar as well. Businesses that fall into this category include salons, restaurants, bars, car washes, and taxi services, according to the IRS. Because there's so much cash, it would be easier for these business owners to hide some of their income from the IRS.

Your Business Is Legally a Hobby

Maybe you breed puppies and sell them. Does this mean you’re self-employed? Possibly, but a whole lot of tax rules determine the distinction between a business and a hobby. You'll be able to get Schedule C tax deductions if you're self-employed, but before taking those deductions, make sure your business isn't legally a hobby. If you haven’t shown a net profit from your business in at least three of the last five tax years, the IRS views it as a hobby. An exception exists if you’re breeding horses—in this case, it’s two out of seven years. You can file Form 5213 to give yourself four more years to generate a profit if you're just starting out and this is your first year at your enterprise. The IRS probably won’t consider your enterprise a business if you don’t depend on the income to make ends meet or devote the necessary time, effort, and money to maximizing your profits. In other words, if you're not making a profit at your business, you have to actually treat it as a job, and work at it for a significant amount of time each day. You'll need records to prove this if you're audited.

You Have Assets or Cash in Another Country

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The IRS is particularly interested in taxpayers who have assets and cash stashed in other countries, particularly in nations with more favorable tax laws than those in the U.S. The IRS has ramped up its rules for overseas assets as well as its scrutiny of such tax returns. The IRS can usually access your account information from a foreign bank, and it will do so if it feels that you might owe taxes on the money you've placed there. In fact, some foreign banks are obligated to provide the IRS with lists of American account holders. You’re obligated to report all foreign accounts with total cumulative balances of more than $10,000 on FinCEN Form 114. Foreign assets valued at $50,000 or more must be reported on IRS Form 8938. Make sure you're as transparent about the value of your assets as possible. If you're concerned about or confused by any of the reporting rules, you may want to consider speaking with a tax advisor.

You Have Investment Income

The IRS receives copies of all information returns bearing your Social Security number. It can be all too easy to overlook or misunderstand some of them, particularly when you have investments. Keep track of all your investment income so you can accurately report it to the IRS. Note You'll receive a letter from the IRS if it receives a 1099 showing that you were paid interest or dividends and it wasn't reported on your tax return. But the letter shouldn't lead to a full audit if you simply agree to the income adjustment and pay the associated tax.

You Claimed the Earned Income Tax Credit (EITC)

Claiming the Earned Income Tax Credit can be an audit trigger, but as long as you're honest with the IRS, EITC audits are typically uneventful and simply lead to less of a refund than you may have initially expected. The EITC is a refundable tax credit that increases with the number of child dependents you have. There are income limits for qualifying as well. The IRS sends you a check for the difference if you're eligible to claim the EITC and the amount of credit you qualify for is more than any tax you owe.

The Bottom Line

If you fill out your tax return as accurately as you can, you're not likely to be audited. If you get audited because you made an honest mistake filling out your tax return, or forgot to include some very small amount of income, you'll probably be able to resolve that with the IRS via mail or over the phone. However, you may need to pay more in taxes or accept a smaller refund. You should claim all legitimate deductions and tax credits. Just keep copies of any paperwork you might need so you're prepared to prove you were eligible for those deductions or credits.

Frequently Asked Questions (FAQs)

How far back can the IRS audit? The IRS can include returns from the past three years in an audit. It generally has three years to assess additional taxes as well. It can request an extension to that statute of limitations, but you don't have to agree. The IRS can also go back further if they find certain errors, although it doesn't usually go back more than the last six years.

thebalancemoney.com - IRS Audit Triggers - The Balance

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