Earlier this year, the IRS announced updates to its Strategic Operating Plan, revealing a significant increase in audits over the next three tax years. Audit rates are expected to climb by more than 50%, with the primary targets being the ultra-wealthy, large corporations, and partnerships. However, individuals aren’t off the hook either as the IRS is expanding its focus to include taxpayers with certain tax patterns that could trigger an audit. In this environment, smart tax planning is more important than ever and understanding what catches the IRS’s attention - and how to avoid it - can save you from unnecessary stress.
To keep things manageable, I’ve divided this topic into two parts. Today’s video, I’ll highlight some common and lesser-known IRS audit red flags for individuals, helping you confidently prepare for tax season and avoid unwanted scrutiny. And next week, I’ll dive into audit triggers specific to business owners.
What’s an IRS Tax Audit?
An IRS audit is essentially their way of double-checking your math. They’re not accusing you of wrongdoing right away - it’s more about making sure everything matches up. But that doesn’t make the process any less stressful or time-consuming. And with increased resources and staff, the IRS is poised to expand its oversight, meaning more people will face the possibility of an audit.
So, how does the IRS decide who to audit? It’s not random.
The IRS uses sophisticated algorithms to flag returns that look unusual based on a combination of data points. Essentially, they’re looking for numbers that don’t add up or patterns that don’t match what they expect for someone in your income bracket or profession.
Let’s break down the most common red flags and what you can do to avoid them.
Major IRS Audit Red Flags
Underreporting Income
One of the most common triggers is underreporting income. This usually happens when you have multiple streams of income and your reported income doesn’t match what the IRS already knows. For instance, they receive copies of your W-2s, 1099s, and other income forms. If you miss something - like freelance earnings or rental income - you’re waving a big red flag.
Always report all your income, no matter how small. Even if you think it might slip under the radar, it won’t.
Excessive Deductions
Another major red flag is claiming deductions that seem excessive compared to your income. Deductions are a great way to lower your taxable income, but they need to be reasonable. The IRS compares your deductions to what’s typical for someone in your income bracket. If something looks out of line, they may take a closer look. This doesn’t mean you shouldn’t claim legitimate deductions - just make sure you have documentation to back them up.
The Home Office Deduction
The home office deduction is one that frequently trips people up. This deduction can save you money, but it’s one of the most misunderstood - and misused - deductions.
To qualify, your workspace must be exclusively and regularly used for business.
That means no shared spaces like your dining table, or a guest bedroom, or a spot where your kids do homework. If you claim this deduction, be ready to provide proof, like photos of your setup or an explanation of how it’s used.
High Charitable Contributions
Giving to charity is wonderful, but if your donations seem disproportionate to your income, it raises eyebrows. For instance, if you’re donating 20% or more of your annual earnings, the IRS might ask for documentation. Always keep receipts, letters from charities, and other proof of your generosity.
Also, failing to get an appraisal for valuable donations or omitting IRS Form 8283 for noncash gifts over $500 greatly increases audit risk.
Conservation easement donations, especially through trusts, face heightened scrutiny as the IRS prioritizes combating abusive schemes, with Congress disallowing deductions in extreme cases.
Gambling Winnings and Losses
Whether you’re betting on slots or horses, gambling winnings must be reported. Failure to report winnings, especially when casinos file Form W-2G, is a common IRS trigger.
Claiming large gambling losses also invites scrutiny. Losses can only offset reported winnings, and recreational gamblers must itemize to claim them. The IRS also flags large Schedule C losses to ensure gambling is a legitimate profession. As always, accurate reporting and documentation are crucial to avoid an audit.
Lesser-Known Triggers
High Refundable Credits
A lesser-known trigger most people don’t think about is claiming high refundable tax credits. Credits like the American Opportunity Tax Credit and Earned Income Tax Credit are designed to help taxpayers, but they’re also prone to abuse since these credits can result in a refund even when no taxes are owed. If you qualify for these credits, that’s great - but make sure you’re following the rules to the letter. Errors in claiming credits can result in an audit and even penalties.
Misreporting the Health Premium Tax Credit
Speaking of tax credits, the health premium tax credit is another area where mistakes can draw IRS attention. This credit helps individuals afford health insurance and when purchasing insurance through a marketplace like healthcare.gov, the credit can be paid in advance to lower premiums but must be reconciled with IRS Form 8962 when filing taxes.
If the actual credit exceeds the advance, you can claim the difference; if it’s less, repayment may be required.
Misreporting this credit is a common audit trigger, especially for incomes above eligibility limits or unfiled reconciliations. Proper reporting is essential to avoid IRS scrutiny and potential penalties.
Frequent Amended Returns
Beyond credits, the IRS is also paying close attention to taxpayers who frequently file amended returns. While it’s okay to correct mistakes, filing an amended return year after year can raise questions. The IRS may wonder why your original returns are consistently inaccurate. To avoid this, aim to file correctly the first time or work with a tax professional to ensure your filings are error-free.
Not Reporting a Foreign Bank Account
The IRS pays close attention to individuals with foreign bank accounts, particularly in countries known as tax havens. Failing to report foreign bank accounts is a major IRS red flag that can trigger audits and lead to severe penalties. If your foreign account balances exceed $10,000 at any point during the year, you must file the FinCEN Report 114 and, in some cases, IRS Form 8938 under FATCA. Unreported assets are treated as potential tax evasion, and the IRS uses data from foreign banks to identify violations.
Penalties for noncompliance are steep, ranging from $10,000 per violation to even harsher consequences for willful failures. To avoid issues, ensure all foreign accounts are reported accurately and on time, file required forms, and maintain thorough records of overseas financial assets. Compliance is key to staying off the IRS’s radar.
Virtual Currency Transactions
The IRS is actively cracking down on taxpayers dealing in virtual currencies like Bitcoin or other digital assets. All taxpayers must now disclose directly on Form 1040 whether they’ve received, sold, traded, or disposed of any digital assets.
For tax purposes, cryptocurrencies are treated as property, and any unreported gains, losses, or income can raise red flags. The IRS has detailed guidance on reporting income, calculating gains or losses, and determining tax basis. Failing to properly report virtual currency transactions can lead to increased scrutiny and penalties.
Advanced Triggers and Risky Transactions
Active vs. Passive Losses
If you have passive losses from activities where you don’t materially participate - such as rental real estate, equipment leasing, S corporations, LLCs, or limited partnerships - avoid using these losses to offset active income. This is a major red flag for the IRS and increases the risk of an audit, especially for large rental real estate losses claimed by those identifying as real estate professionals. Remember, passive losses can only offset passive income unless you actively participate in managing your rental property, so be sure to follow the rules carefully.
Listed Transactions
The IRS also maintains a list of Listed Transactions which are specific arrangements it views as tax avoidance schemes. While not necessarily illegal, these transactions are considered abusive and must be disclosed to the IRS. Failure to report participation in these transactions using Form 8886 can significantly increase your risk of an audit.
Some examples of Listed Transactions include Inflated Partnership Basis Transactions (commonly called “Son of Boss”), Abusive Roth IRA Transactions, and Distressed Asset Trust transactions.
IRS "Dirty Dozen" List
Finally, pay close attention to the IRS “Dirty Dozen” list. This is an annual compilation of the most common and egregious tax scams that taxpayers might encounter. The IRS wants you to stay vigilant and skeptical of any offers or communications that seem too good to be true.
If your tax advisor helps you implement a strategy listed on the “Dirty Dozen” or as a Listed Transaction, they are required to file Form 8918, the Material Advisor Disclosure Statement. This filing notifies the IRS to closely examine those transactions and the clients involved, increasing the likelihood of scrutiny.
Final Thoughts
So, how can you protect yourself? First and foremost, accuracy is key. Double-check everything on your return before you file. Make sure your income, deductions, and credits are reported correctly. It’s also a good idea to keep detailed records of all income and expenses throughout the year. That way, if the IRS has questions, you’re ready with answers.
Another way to reduce your audit risk is to work with a tax professional. They can help you navigate the complexities of the tax code and ensure that your return is accurate and compliant. A professional can also spot potential red flags before you file, saving you time and stress down the road.
One thing to remember is that honesty is always the best policy when it comes to taxes. It might be tempting to exaggerate a deduction or leave off a small income source, but the potential consequences aren’t worth it. The IRS has more tools than ever to spot discrepancies, and getting caught could mean not only an audit but also penalties and interest on any unpaid taxes.
At the end of the day, the goal isn’t to avoid paying taxes - it’s to file an accurate return that minimizes your tax liability while staying within the rules. The IRS isn’t trying to trip you up; they’re just doing their job. By understanding what triggers an audit and taking proactive steps to avoid those triggers, you can file your taxes with confidence and peace of mind.
If you’d like to explore strategies to minimize your taxes which staying compliant with IRS rules, feel free to schedule a complimentary meeting.
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