Tax Audit – how to avoid an IRS audit

First Financial Starting a Business, Taxes 0 Comments

Tax Audit – Why do people get audited?

In 2012, the Internal Revenue Service (IRS) collected more than $2.5 trillion in revenue and processed more than 237 million tax returns.  In 2014, the IRS conducted tax audits on only 0.86% of all individual returns.  While that is a very small percentage of tax audits, there are ways to further decrease the odds that you will have to deal with a tax audit.  On the other hand, there are some red flags that may greatly increase your changes of an audit.

This IRS has a goal of collecting as much tax revenue as possible for the least amount of money spent.  For example, the IRS spent just 48 cents for each $100 it collected in FY 2012.  There is a cost to conducting a tax audit, which is why the IRS try to do it in the most efficient way possible.

Tax Return Red Flags that May Trigger a Tax Audit

Having a large amount of income

Remember, only 0.86% of individual returns are audited.  If you make more than $200,000 your tax audit chances climb to 2.71%.  If you make more than $1,000,000 you can count on 7.7% of those individual returns being audited.  Of corse making a lot of money is a good thing, just be prepared to prove you’re not cheating on your taxes.  Logically, if it costs the IRS roughly the same amount for the tax audit of an individual, they are going to target people with the largest potential unpaid taxes.

Not reporting all Taxable Income that the IRS has been Notified about

Income, other than a check from grandma, typically gets reported to the IRS via forms 1099 or w-2.  A 1099 will be generated by a company who pays you individually (not to your business) as an independent contractor for instance.  At the end of the year those who “1099ed” you typically send you a copy in the mail.  If you have moved or they sent it to the wrong address, you can still get copies of your 1099 directly from the IRS.  A good CPA can have you sign a power of attorney and request this information for you in preparation for your tax return.  W-2’s (one from each job) is your reported income as an employee and should be accounted for in your return.

If the income you state on your tax return doesn’t match the amount the IRS is expecting you to report via your 1099 and w-2, that’s a red flag.

 Claiming Larger than Average Deductions

Claiming deductions reduces your taxable income (the IRS hates this).  You are legally entitled to deductions and you should deduct everything you are legally allowed to.  Some people are less conservative than others when it comes to what’s deducted.  Do you deduct 20% or 30% of your mortgage for a home office/meeting space?  50% or 100% of your internet bill?  It’s best to consult a CPA to determine what percentages are most acceptable and what documentation is necessary in case you’re audited.

Bottom line, if you want to avoid an audit, be sure to stay within the normal range of deduction percentages.  Consult a qualified CPA or tax attorney if you are unsure about what qualifies as a legitimate deduction and how to document said expense.

 

Owning a Small Business may trigger a tax audit

There are many tax advantages to owning a small business.  As a business you are typically entitled to more deductions than an individual.  Is that “business trip” really a “vacation”?  Can you pay your kids to help around the office?  Is your conference room really the dining room?  There are many deductions available, but be careful about which ones you take advantage.  The line between personal and business expenses is sometimes in a grey area and often proper documentation and procedure is the difference between legitimate expenses and tax cheats.  Once again, a CPA or tax attorney should be consulted if you’re unsure how or if you should deduct an expense.  RECOMMENDED READING FOR SMALL BUSINESS OWNERS: Tax This: An Insiders Guide to Standing up to the IRS

Large Charitable Donations

The IRS has a good idea of the average donation amount of someone with your income.  To avoid a tax audit, be sure to follow these guidelines.  If you donated valuable property, have a copy of it’s appraisal to prove your donation value.  For non cash donations over $500 or cash donation over $5000 be sure to file form 8283.  Make sure you keep all donation receipts.  See the IRS tips for charitable deductions

Losses from Rental Property

Passive loss rules prevent the deduction of rental real estate losses, however there are two exceptions.  One, If you actively participate in the renting of the property, you can deduct $25,000 of loss against your other income.  This deduction is reduced once your adjusted gross income exceeds $100,000 and disappears beyond $150,000 AGI.

Two, if you are a real estate professionals and spend more than 50% of your working hours and 750 or more hours annually engaging in real estate as a developer, broker, landlord or the like, you can write off losses without limitation.

If you have rental property and want to avoid issues during a possible tax audit, you should read the IRS guide to residential rental property tax returns

Hobby Activities

If you make income from your hobby, you must report it.  You can deduct expenses up to the amount you made from the hobby.  To claim a loss, there must be reasonable expectation to make a profit under the IRS code.  If your activity generates profit three out of every five years, the IRS presumes that you’re in business to make a profit, unless they establish otherwise. Make sure you conduct your hobby like a business and can provide supporting documents.

Meals, Travel and Entertainment for Business

Large deductions for meals, travel or entertainment are a red flag for the IRS.  Without proper documentation, you can’t claim a deduction.  You must keep a record of each expense amount, where is was, what people were there and what the nature or purpose of the meeting or discussion was.  For any expense over $75 you will also need the receipt.

Not reporting a foreign bank account

This is particularly an issue for dual citizens, who may not be aware of the IRS requirements to report foreign income and accounts.  You may have heard of people hiding income in foreign accounts and tax haven countries.  This rule was put in place for tax cheats and carries heavy penalties for non compliance found during a tax audit.  The properly report a foreign bank account visit this U.S. Treasury Website.

 Claiming that 100% of your vehicle expenses is for business

The IRS know that in general vehicles are also used for personal reasons, especially if there is no other vehicle available for personal use.  Claiming 100% of your vehicle expenses is business related is a red flag likely to trigger a tax audit.  Using the standard millage deduction is usually a good choice.  See this IRS publication for more information about deducting vehicle expenses.

Home Office Tax Deduction

If you qualify,  you can deduct a percentage of your rent, real estate taxes, phone bills, utilities, insurance, office supplies and other costs related to the home office.  Alternatively, there is a simplified option for claiming this deduction.  A standard rate of $5 per square foot of space used for business, with a maximum deduction of $1,500.

To take advantage of this tax benefit, you must only use the space on a regular basis as your primary place of business. Exclusive use of an area means only for trade or business, dual propose spaces such as second bedrooms or dining room table don’t count.

Because IRS agents have historically had success in reducing the amount deduced from home office expenses, they are more likely to audit this deduction.  Be sure to have proper documentation about how you use the space you’re deducting.

 

DISCLAIMER

First Financial researches and provides this information to the best of our abilities.  We are not CPA’s. We are not tax attorneys.  We recommend you always consult a tax professional  and conduct your own due diligence before you follow any advice you read on this website or other blog.

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