What Will trigger an IRS Audit?

As a Texas IRS audit and tax defense attorney, the team here at Ronald Arthur Stearns Sr. PLLC know how stressful preparing your tax return can be. Even when you are completely honest and thorough in filing your tax returns, it is normal to feel anxious, and many of our clients come to us worried about tax audits and for advice on what can trigger them.

Due to the federal budget cuts that have affected the number of staff that work in the IRS audit department, fewer than 0.25% of individuals are now audited, which is only 25% of the number of people that were audited on a yearly basis each year a decade ago.

However, just because the number is small, we still recommend speaking to a tax attorney, as they will ensure there are no mistakes made on your return, decreasing your chances of an audit. We know the mistakes that taxpayers often make, mistakes that can lead to a higher chance that your returns are examined with more scrutiny.

What will trigger an IRS Audit – Key Points

• The computer system that is used by the IRS uses a specific algorithm designed to flag tax returns with certain discrepancies or abnormalities.
• You should always report all forms and streams of income that you gave to the IRS. This includes gambling winnings, cryptocurrency transactions, and investments that return income.
• If your business involves taking large cash transactions or makes large cash deposits on a regular basis, this can be a trigger for an audit.
• Foreign income and assets are also common red flags.

IRS Computer System

The IRS utilizes a complex and powerful computer-based algorithm known as the DIF, which stands for the Discriminant Information Function. This system has the sole purpose of discovering discrepancies in the vast number of tax returns filed every year. It takes each return and scans it, looking for things like deductions and credits that don’t make sense and any duplicate information.

At its core, it works by comparing each result to a template of what is thought to be a correct and reasonable return for the same earnings. If you earn $50,000 per and donate $20,000 to charity, for example, then try to claim a deduction, this would flag up as very few other taxpayers who earn that much would be doing this.

This computer system allows vast numbers of returns to be examined without any human input. If your return flags up on this system, it is noted, and then your return will be examined by a human investigator.

How Income Affects Audits

The IRS will only employ its resources and order an audit on cases where they are fairly certain that it will be able to collect money from a taxpayer that owes more tax than they have paid. This usually means that the more you earn, the higher the risk of a full-blown audit.

In fact, the majority of audits that are carried out every single year are on taxpayers who earn over $500,000 dollars or more. These are the earners that see an increased risk of audit, with over 1% of them being audited.

According to the numbers, if you earn between $25,000 and $500,000 you are in the least likely band of taxpayers to be audited, but bear in mind, this does not mean it does not happen to those in this bracket because it does.

Reporting Your Income

As an employee, your employer must issue what is known as a W-2, detailing your earnings to both you and the IRS.

Independent contractors who are paid more than $600 dollars in a single year must also file a form, known as a Form 1099.

If you have earned interest or dividends of over $600 dollars, you should expect a Form 1099 INT/DIV at the end of the year, and the IRS will also receive a copy.

These forms feed directly into the DIF, meaning that your tax return needs to include them if you do not want it to flag up.

Remember, almost all income that you may receive needs to be reported for federal income tax purposes. This is one of the biggest IRS audit triggers and includes tips, cash, or freelance income.

Large Cash Deposits

The Bank Secrecy Act states that many types of businesses have a legal requirement to report to the IRS if they engage in cash transactions of more than $10,000 dollars. This is designed to prevent money laundering and illegal activities.

The IRS will always be concerned if they see that you have put down a lot of cash on a deposit or purchase and the amount of cash does not line up with your personal expenses and income.

If you do make a deposit of over $10,000 dollars into any bank, it will be reported to the IRS, and you should expect them to query where and how you have received the money.

The IRS will be notified if you make a large deposit over the $10,000 amount. You should be prepared to show how and why you received that money if you file a tax return.

Claiming Too Many Itemized Deductions

Claiming too many tax deductions, such as business expenses or a home office deduction for a large amount, may trigger an audit too.

For this reason, if you are going to make a charitable donation, you need to keep a receipt and submit it alongside Form 8283 when you file your tax return. This appraisal needs to be done for any charitable donation of more than $5000.

You’re Self-Employed

As a self-employed freelancer or sole proprietor, you gain several benefits in terms of your tax liability, such as the ability to deduct expenses for mileage, meals, and travel. These benefits must be accounted for on your earnings and reported accurately.

Another common IRS audit trigger is when your deductions do not match the other taxpayers in your profession. If freelancers in the same role as you regularly spend 10% of their reported income on expenses, but you have spent 30%, there is a good chance the DIF will flag your return to the internal revenue service.

You should never stretch or lie about your returns on a tax return form, as you will be expected to prove them if you are audited. If you report that your car is solely used for business purposes, for example, and the mileage does not match your claims, you may be punished.

Your Business Is Home-Based

Claiming a home office deduction may lead you to higher levels of scrutiny compared to those that can show their expenses on hiring office space. If you are going to claim a home office deduction, the area you use as a home office must not be used for any other personal reasons.

You Own a Cash Business

Businesses that solely rely on cash or a high level of cash transactions are often at a higher risk for an IRS audit. This is because the high amount of cash is more likely to result in false income reported to the IRS.

Your Business Is Legally a Hobby

For some people, a hobby may evolve to a point where it begins to earn you money. For example, if you bake cakes for a family member’s birthday, then their friends hire you to make a cake for their son’s birthday, it may be difficult to know where you stand taxwise.

If your hobby has not shown any net profit from three of the last five years, then it is classed as a hobby in the eyes of the IRS.

Owning Assets or Cash in Another Country

The IRS will always keep an eye on any taxpayer they know to have assets or cash in other countries, especially if it is because the tax laws in those countries are more favorable. In recent years the IRS has become more strict in this regard and has ramped up the laws and scrutiny for individuals and businesses that work in multiple countries.

The IRS usually has the power to demand information regarding your accounts from foreign banks and companies. Many foreign banks have a legal obligation to provide this information to the IRS when asked.

You have a legal obligation to report if you have foreign accounts that have a total cumulative balance of more than $10,000 dollars.

You Have Investment Income

The IRS typically investigates investment income by reviewing financial records and documents, as well as conducting interviews with the taxpayer. In addition, the IRS may review business or individual tax returns to determine if income or losses have been properly reported.

The IRS also has access to a variety of records, such as brokers’ statements and financial institution records, to determine if taxes have been paid on the income, such as capital gains. If suspicious activity is detected, the IRS may refer the case to its Criminal Investigation Division for further investigation.

You Claimed the Earned Income Tax Credit (EITC)

If you claimed the earned income tax credit, it could increase your risk of an audit. However, as long as you have been upfront and honest, EITC audits are usually simple and mean you will just receive less of a refund.

The Bottom Line

Filing your tax return correctly is essential for a number of reasons. First, it ensures that you don’t have to pay more taxes than you owe. It also prevents you from being in a situation where you owe the government money that you can’t afford to pay.

Second, it helps you maximize your tax deductions so that you can get the most out of your tax return.

Finally, filing your tax return correctly can help you avoid any potential legal issues with the IRS or other tax authorities. For these reasons, it is important to take the time to make sure your tax return is filed accurately and completely.

However, this process can be complex and time-consuming. As a result, it is often best to seek the help of a skilled tax attorney or accountant who has experience dealing with the IRS and other tax authorities.

A good tax attorney or accountant can help ensure that your taxes are filed correctly and on time, as well as help maximize any deductions or credits that you are entitled to receive. They can also provide guidance on how to handle any disputes you may have with the IRS or other tax authorities.

Frequently Asked Questions (FAQs)