Audit Flags: Tax Preparation

(3 of 8)

Audit Flags: Tax Preparation

Only about one percent of individual tax returns get audited by the IRS. It does not have enough resources to go after many more, so to make its work more efficient, the IRS relies on certain suspicious things in tax returns. These predictable things are called audit flags (or red flags to some) because they are ways that some people try to hide income from the IRS. Let’s look at some major audit flags.

Math mistakes

Math errors are the most common reason for getting audited. Luckily, they rarely lead into deeper levels of the audit process. If you receive a letter from the IRS claiming that you owe more money, keep math mistakes in mind and redo your numbers. The error may be yours, or it may be an innocent clerical error on the IRS’s part. If it is the latter, simply print out your new calculations, write the IRS an explanatory letter, and mail them both off.

Income discrepancies

The IRS receives the same W2s and 1099 forms that you do. It matches the amounts on them with the amounts on your tax return. If your supporting forms—W2, 1099(s), and interest and dividend forms—don’t match your tax return, the IRS will send you a letter seeking clarification. But sometimes a mismatch comes from human error at the IRS. In that case, you will have to clarify the amounts reported, using documentation from whoever reported the income on your forms. You can prevent many of these errors by simply including copies of these forms with your tax return.

Hobby losses

Some people like to deduct expenses for money-generating activities that might look like businesses but are actually hobbies. The IRS trains its agents to look for these. Hobby losses are not deductible. For most activities, if it creates a profit in three out of every five years, you are considered in business.

Cash businesses

Those who get paid a large percentage of their earnings in cash are particularly prone to underreporting it (partly because the party that pays them doesn’t always report it). The IRS knows all about this. One way it can tell is when an individual’s lifestyle seems especially luxurious compared to his or her reported income. This can happen when deductions are disproportionately high or when reported income is disproportionately low. So if you are reporting only $10,000 a year in income but you bought a $250,000 home this year, Uncle Sam may notice.

Foreign bank accounts

If you have a bank account in some other country, especially if that country is a tax haven, make sure the IRS knows about it. If you don’t, there are big penalties.

Large cash transactions

Doling out a huge sum of cash can make IRS audit agents look twice at you. They have ways of finding out about these things. These transactions are not illegal; they just look like evidence of money laundering. If you are depositing large sums of cash into bank accounts, if you are depositing large sums that are just under the limits for reporting (banks must file reports on large deposits), or if you purchase something for a very large amount of cash, that will look suspicious.

Talking about it to others

Some people like to boast about how they got away with this or that write-off. Be careful where you boast, because your fellow citizen could report you. Also, the IRS now trolls social media. It typically looks for known tax evaders in order to gather evidence, but bets are not off for those cheating for the first time and bragging about it.

Overzealous tax preparers

Are you hiring a tax preparer because he or she is promising you a refund despite not having looked at your paperwork yet? If so, that person may be planning to take inflated deductions or, worse yet, deductions you aren’t even entitled to. Should the IRS find out, you’ll be hit with penalties and interest.