What is an IRS audit?
The IRS may choose to review a taxpayer’s accounts and financial information to ensure they followed all tax laws. Even though the IRS audited only 0.3% of individual income tax returns in 2020, many taxpayers live in fear of a letter from the bureau questioning items on their returns.
“Taxpayers worried about the possibility of facing an IRS audit may hesitate to claim all the tax breaks they are entitled to claim,” Kathy Pickering, chief tax officer at H&R Block, says. “When they do this, they are leaving their money on the table.”
The IRS generally has up to three years after the filing deadline to initiate an audit, or up to six years if you omit 25% or more of your income. “If you are entitled to deductions or losses and you have adequate documentation to support these expenses, a taxpayer shouldn’t fear an audit, even though it might be stressful,” Mitchell Freedman, certified public accountant in Westlake Village, California, says.
Keep reading to find out which red flags can trigger a tax audit and what you can do to avoid problems with the IRS.
You didn’t report all of your income.
You’re not the only one who receives W-2 forms and 1099s reporting your income; the IRS gets copies, too. If the numbers are different, expect to hear from the IRS.
“It is almost automatic that the IRS will do a cross-check to make sure all of the income reported on Form 1099 is also reported on the appropriate lines of the tax return,” Freedman says. “If you haven’t reported income from the various forms, 1099s, W-2s or K-1s, you will likely be audited.”
As you gather your tax records before you file, make sure you’re not missing any W-2s or 1099s — especially if you did freelance work for several employers or changed jobs in the middle of the year.
“The surest way for a taxpayer to get a letter from the IRS is to omit any amount of income from your return,” Pickering says. “The IRS can easily check income reported on tax returns against what employers, banks, brokers and others report. This is an honest mistake for many who have taken up second short-term part-time jobs or side hustles.”
Keep these records even longer than usual. Remember the IRS has up to six years to initiate an audit if you’ve neglected to report 25% or more of your income.
Also, don’t forget about any income you report on Form K-1. “Forms K-1 are used to report income and other items from S-corporations, partnerships, LLCs, and trusts and estates,” Freedman says. “Each year more taxpayers are receiving these forms, and they are also provided to the IRS.”
You took the home office deduction.
Many people are afraid to take the home office deduction because they worry the write-off will lead to an audit. This can be a valuable break to help cover the costs to set up and maintain an office in your home, but not everyone who works from home is eligible. You can take the home office deduction only if you are self-employed or an independent contractor.
To qualify, you must use part of your home “regularly and exclusively” for business. Your office doesn’t need to be in a separate room, but it has to be in an area of your home where you don’t do anything else. The space must also be your principal place of business or a place where you meet regularly with clients or patients.
You can deduct your actual expenses, including a portion of your mortgage interest, renters or homeowners insurance and utilities based on the area of your home that you use as an office. Keep records of all those expenses.
Or you can use the simplified option: Just deduct $5 per square foot of your home office (up to 300 square feet) for a maximum deduction of $1,500. If you did freelance work or were self-employed for a few months, you may be able to take a partial-year home office deduction.
You reported business losses.
You can deduct a lot of expenses when you have a business, but the IRS wants to make sure you didn’t set up a questionable company just to benefit from the deductions.
In some years, your business can have more expenses than income, especially when you’re getting started, but the IRS gets suspicious if it never makes a profit. An audit red flag is businesses with net losses year after year or businesses that appear to barely break even.
If your business has had a profit in three of the past five years, the IRS considers it a business, not a hobby.
“Just because a business doesn’t meet the three-of-five-year profit (rule) doesn’t mean that a taxpayer can’t continue to deduct losses on business, but the taxpayer must be able to prove … that there is a profit motive,” Freedman says.
Keep detailed records of your expenses and your business plans. “If someone has a side hustle business and claims deductions, it needs to be a business,” Annette Nellen, CPA, professor and director of the Masters of Science in Taxation program at San Jose State University, says.
“There must be a profit motive ideally supported by a business plan. There must be appropriate records of revenue and expenses. For a loss over one or two years, the taxpayer needs to have a plan for how to avoid that in the future. The taxpayer needs to show they are knowledgeable about their business, such as by keeping up to date with industry trends,” she says.
You had unusually large business expenses.
You may hear from the IRS if your business expenses are much larger than other similar types of businesses. “The IRS compares deductions taken by taxpayers in the same income bracket or business type to find inconsistencies,” Pickering says.
Keep detailed records of your business expenses for at least three years after the tax-filing deadline and at least six years if you’re receiving income from a variety of sources, especially for years during which you have large expenses.
Take steps to separate your business and personal expenses. “Maintain a separate bank account if you are self-employed, and make sure all income is deposited and expenses are paid through the business account,” Pickering says.
“That way, you have a clear financial record. Keep records such as logs and calendars documenting the work you’ve done as well as receipts, so you can show the business purpose of your expenses. If you pay expenses through a credit card, it’s a good idea to have a separate card for your business,” she says.
Another audit red flag is claiming you use your car 100% for business instead of allocating between business and personal use, Freedman says. Keep a mileage log so you can calculate the portion of the time you use the car for business — and to help defend your case if you’re audited.
You didn’t report all your stock trades.
Stock trades are taxable when you sell the shares, unless the investments are in a tax-deferred retirement account. The brokerage firm sends a copy of Form 1099-B to you and the IRS, and you need to report the capital gains and losses on Schedule D when you file your income tax return.
Investments you’ve held for less than year are considered short-term capital gains and are taxed at your income tax rate. Investments you’ve held for longer than a year are generally taxed at the lower capital gains tax rate, which is currently 0%, 15% or 20%, depending on your bracket. Forgetting to report information from Form 1099-B — or any big change in your capital gains income — could lead to an audit.
You didn’t answer the question about digital cryptocurrency payments and assets.
The IRS has asked about virtual currency transactions on the front page of Form 1040 since 2020, and it plans to expand the question and guidance about the types of taxable transactions for 2022 returns.
This is the new IRS question in the draft of the 2022 Form 1040: “At any time during 2022 did you receive as a reward, award or payment for property or services, or sell, exchange, gift or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”
“Taxpayers must answer the question yes or no, and omitting it would certainly slow up the return if not trigger an audit,” Pickering says.
If you receive cryptocurrency or other digital assets as income or have a profit or loss from selling digital assets, you usually need report it. For federal income tax purposes, digital assets are taxed like any other kind of property, and if you sell cryptocurrency or other digital assets you must recognize any capital gain or loss.
You made large charitable contributions or didn’t include required documentation for them.
Charitable contributions can be tax-deductible if you itemize, and it’s important to keep detailed records when you donate.
“If someone donated cash or noncash items to a charity in the amount of $250 or more and itemizes deductions, they can only claim that deduction if they have the required contemporaneous written documentation from the charity,” Nellen says. “It is the donor’s responsibility to get the proper letter.”
That means you can’t just get a letter form the charity years later if you’re audited: You need to have the documentation by the time you file your income tax return claiming the deduction. There are additional record-keeping requirements to substantiate large noncash donations, such as clothing, household supplies and vehicles, Pickering says. For example, you must have a qualified appraisal for noncash contributions in excess of $5,000 — in addition to written acknowledgment from the charity.
You may also trigger an audit if you forget to attach required documentation for noncash charitable contributions, Brad Sprong, national tax leader, KPMG Private Enterprise, says. For example, if you donate property worth more than $500 — whether it’s a single item or a group of similar items — you must attach Form 8283 when you file your return.
You earned a lot of money.
The more you earn, the more likely you are to be audited. For 2019 returns, the IRS audited 0.2% of taxpayers who earned $25,000 to $500,000. But the audit rate rose to 0.6% for those who earned $500,000 to $1 million, 1.3% for $1 million to $5 million, 2.0% for $5 million to $10 million and 8.7% for taxpayers who earned more than $10 million.
It pays to be extra careful when reporting your income and substantiating your expenses and other deductions at higher income levels. It’s a good idea to work with a CPA or enrolled agent who knows the rules and record-keeping requirements. They can help if you’re audited and also come up with a plan to help minimize your tax liability in the future.
You may also be at a greater risk of being audited if your income is volatile from year to year, Sprong says. And the IRS audits people with very low reported income at a higher rate — in 2019, it audited 1.1% of tax filers who claimed no positive income.
You made errors.
The IRS also audits returns that contain basic mistakes such as incorrect Social Security numbers and math errors. You may face extra scrutiny if you rounded the numbers for your expenses instead of reporting the specific dollar amounts.
“Numbers entered on the return which appear to be estimates, rather than actual numbers — such as amounts entered to the nearest $100 or $1,000 — appear to be pulled out of the air,” Freedman says. Check your work before you submit your return.
What happens if you’re audited?
“Many audits start with a simple notification letter sent to the taxpayer,” according to Timothy Stiles of KPMG.
“This may be automatically generated by the tax authorities, for example, when a 1099 was reported by a payer, such as a bank, but the individual doesn’t show any income from the bank on a tax return. Another example is a large transaction reported in a single year, perhaps from the sale of a home or business. The IRS typically identifies the issue and asks for a response,” he says.
As soon as you get the letter, gather your records and make your case. “A good recommendation is to send clear, concise documentation with a simple explanation in response,” Stiles says. In many cases, that may be all you need to do.
Pickering adds that most audits are conducted by mail and resolved by sending supporting documents with an explanation. “If a face-to-face meeting is required, having a tax professional represent them could make some taxpayers feel more comfortable, prepared and knowledgeable about what to expect.”
If you worked with an enrolled agent or CPA, let them know about the audit. They should be able to help and can represent you. If you filed your tax return through a tax preparer or software service, they may be able to help, too. For example, you can sign up for the TurboTax audit defense program for an extra fee when you file your taxes.
Tax audit triggers:
— You didn’t report all of your income.
— You took the home office deduction.
— You reported several years of business losses.
— You had unusually large business expenses.
— You didn’t report all of your stock trades.
— You didn’t report cryptocurrency payments and assets.
— You made large charitable contributions or didn’t include documentation.
— You earned a lot of money.
— You made errors on your return.
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Update 01/05/23: This story was published at an earlier date and has been updated with new information.