According to the IRS, the percent of all tax returns audited for tax year 2017 was 0.5%. That number went down to 0.45% for tax year 2018. The even better news is that most of the returns audited were done so via correspondence – 74.8% of all audited returns filed in 2017. So, the likelihood that you will be audited is slim, about one in 5,000.

This does not mean, however, that you can or should become lackadaisical in preparing your returns. There are certain “red flags” that can increase your chances of being in the IRS’s crosshairs. There is no way to 100% safeguard against an IRS audit, but, by paying attention to and being aware of these red flags, you can avoid mistakes that may bring attention to your return and be prepared if you are audited.

  1. Using Overly Rounded Numbers on Your Return

When you buy gas, go out to eat, make any kind of purchase, how often does the payment amount turn out to be a perfectly round number? Rarely if ever, right? The same applies to deductions you claim on your tax returns. A long list of round numbers attracts attention. While a certain amount of rounding is acceptable – to the nearest dollar – with today’s electronic receipts an exact figure, if available, is the best choice.

  1. Using the Wrong Social Security Number

In a world fraught with heightened concern regarding identity theft, returns using an inaccurate social security number, or submitting documents with inconsistent social security numbers, will catch the eye of the IRS. Not only could this lead to the scrutiny of the IRS, it may result in a rejection of the return. Be sure to double check all documents for correct social security numbers. If there is a mistake correct the document or request a new document with the correct information.

  1. Failure to Report All Taxable Income

Copies of all 1099s and W-2s you receive are sent to the IRS. They are aware of all income you receive before you even file your return. An inconsistency in the information you submit, and the IRS receives will send up a red flag for the IRS and their computers will issue you a bill. Regardless of whether you receive documentation, such as a 1099 – be sure to report all income sources on your Form 1040. If you receive a 1099 or W-2 with inaccurate information or that is not yours, have the issuer file a corrected form with the IRS.

  1. Claiming Day-Trading Losses on a Schedule C

There is a distinct difference between a trader and an investor. An investor profits on long-term appreciation and dividends. A trader, however, must buy and sell securities frequently with the goal of profiting on short-term swing in prices and the trading activity must be continuous. If you fall under the classification of trader, your expenses are fully deductible and should reported on your Schedule C. Your profits are also exempt from self-employment tax. Losses are only deductible to traders who make the 475(f) election. These losses should be treated as ordinary losses that are not subject to the $3,000 cap on capital losses.

  1. Failing to Report a Foreign Bank Account

Failure to report a foreign bank account to the IRS can result in severe penalties and throw up a red flag for an audit. If you have foreign accounts that combined had more than $10,000 in them at any time during the previous year, you must report them properly by electronically filing FinCEN Report 114 (FBAR) by April 15. If you have a lot of financial assets in foreign accounts, you may also be required to file IRS Form 8938.

  1. Collecting an Unusually Low Salary

The IRS examines the compensation practices of corporations, especially S Corporations and the salary paid to the principal owner. If the principal owner’s salary is unusually low compared to corporate revenues, a red flag will be raised by the IRS. Additionally, the principal owner drawing an unusually low salary can pierce the corporate veil, removing ant asset protection in place for the corporation.

  1. Hobby Losses

Per the IRS, there are very specific rules and guidelines defining what constitutes a business and what constitutes an expensive hobby. To take any loss as a deduction, the activity must be run as a business and have a reasonable expectation of generating a profit. If your activity generates a profit three out of every five years (two out of seven years for horse breeding), the IRS assumes you are in business to make a profit. As with any business, be sure to keep all documentation establishing the activity is being run as a business with the goal of profit and to document all deductions properly per IRS standards.

  1. Owning a Cash Business

Businesses that deal in cash – think bars, restaurants, convenience stores – are easily able to misreport or hide income. The IRS is aware of this fact and tends to scrutinize owners of cash businesses more highly. Your best defense is to ensure you keep precise and accurate documents of all financial transactions.

  1. Big Changes in Income

Regardless of whether the change is to the upside or downside, the IRS notices big swings in income. If you do have a big change in your income, be sure that you have documentation explaining the change.

  1. Early Payout from an IRA or 401(k) Account

Payouts on an IRA or 401(k) before age 59 ½ are subject to a 10% early withdrawal penalty in addition to the regular income tax due unless a special exception applies. The IRS has a chart on their website outlining the exceptions for each type of account to the 10% penalty, which includes disability, education, medical costs and rollovers. An IRS review of those scrutinized in 2015 found that nearly 40% made errors on their tax returns with respect to retirement payouts. This has brought high scrutiny from the IRS. If you do take an early withdrawal, but sure you understand the rules, pay the 10% early withdrawal penalty if applicable and properly report your withdrawal on your income tax return.

  1. Deducting Business Meals, Travel and Entertainment

One of the biggest red flags for the IRS is big deductions form meals and travel taken on a Schedule C by business owners. The Tax Cuts and Jobs Act of 2017 amended the allowances and even eliminated some of the deductions for entertainment expenses, such as golf fees and tickets to sporting events. You can deduct the cost of a meal up to 50%; however, to qualify for the deduction, you must keep detailed records as to the amount, place, people attending, business purpose and nature of the discussion or business conducted. Meals deemed extravagant will be disallowed. Actual receipts must be provided for all expenses over $75 or for lodging while traveling.

  1. Running a Business

Unfortunately, running a business is an automatic red flag for IRS agents who scrutinize sole proprietorships – whether big or small – to determine if excessive deductions are being taken or if income is being underreported. But just because you run a business does not mean you have done anything wrong. The scrutiny is a result of those who are unscrupulous and put the spotlight on everyone. As mentioned above, those operating cash-intensive businesses, as well as those reporting at least $100,000 in gross receipts on the Schedule C, and business owners reporting a substantial loss are at a higher risk of scrutiny. Your best defense is to make sure you have complete and accurate documentation of all your financial transactions.

  1. Making a Lot of Money

Again, as with owning a business, making a lot of money can be a red flag for the IRS and cause an audit. IRS statistics show that individuals with incomes between $200,000 and $1 million who filed a Schedule C in 2018 were audited at a rate of 1.4% compared with the overall 0.5% audit rate. And, as your income increases, especially for those earning $1 million or more, the chance of audit also increases. Once again, your best defense is to make sure you have complete and accurate documentation of all your financial transactions.

Remember, just because you are being audited does not in any way that you have done something wrong. Audits are a system of checks and balances to ensure that the general public is being honest and paying to Uncle Sam his or her fair share. That does not mean that you should not take all of the deduction to which you are entitled. The key is to make sure you have the proper documentation in place to legally legitimize the deductions you are taking and your financial position. Tax Saving Professionals can help you identify the strategies that will offer you the most tax-savings, guide you through the strategies available to you to maximize your tax savings and ensure that you have the proper documentation to legally take all the deductions to which you are entitled. To learn more, call us at (772) 257-7888.