You might be afraid of a threat from an Internal Revenue Service (IRS) audit. What happens if you unintentionally make a mistake that sets off an IRS tax audit? While most tax returns are simply processed without additional review or investigation, there are some factors that can cause your personal or company tax return to be further investigated, or even audited. Worry not, however: with the assistance of a seasoned business accountant, you can successfully minimize your risk of IRS examination concerns.
Contents
- 1 What is an IRS Audit?
- 1.1 Most Common IRS Audit Triggers
- 1.2 The following are 12 IRS audit triggers to know
- 1.2.1 1. Math Mistakes and Typos
- 1.2.2 2. High Income
- 1.2.3 3. Unreported Income
- 1.2.4 4. Too Many Deductions
- 1.2.5 5. Schedule C filers
- 1.2.6 6. Holding Foreign Financial Assets
- 1.2.7 7. Having Neat, Round Numbers
- 1.2.8 8. Home office deduction
- 1.2.9 9. Deducting Entertainment, Travel, and Meals Expenses
- 1.2.10 10. Making Transactions Involving Digital Assets
- 1.2.11 11. Earned Income Tax Credit (EITC)
- 1.2.12 12. Early Retirement Account Withdrawals
- 1.3 How Far Back Can the IRS Audit?
- 1.4 How Many Years Should You Hold onto Tax Records?
- 1.5 FAQs
What is an IRS Audit?
An IRS audit is a formal examination by the Internal Revenue Service of a company’s or taxpayer’s tax return, documentation, and other financial accounts and records to verify the truthfulness of information reported on the return, such as the income reported.
The percentage of individual tax returns selected for an IRS audit is fairly low. According to Scott Hipp, CPA, in 2022, only 0.49% of individual tax returns were selected for audits, or fewer than one in every 100 returns.
Most Common IRS Audit Triggers
But just because there is a low probability of being audited doesn’t imply that it can’t happen to you, and the IRS continues to expand its use of automated programs to select tax returns that it considers to require more examination. To lower the likelihood that your tax return is audited, you should know some things that are prone to triggering returns for additional IRS scrutiny.
The following are 12 IRS audit triggers to know
1. Math Mistakes and Typos
The IRS also has programs that verify the math and computations on returns. If your return “doesn’t add up,” it will be referred for further examination. You should always double-check your calculation and your Social Security number.
2. High Income
The higher your income, the greater the chances that the IRS will come knocking, because the IRS usually audits those earning $500,000 or higher at higher-than-average rates.
3. Unreported Income
The IRS receives your copies of your W-2s and 1099s, and their computers automatically check what you’ve reported on your return against this data. A discrepancy, such as a 1099 that you’re not reporting on your return, could lead to an audit. So, if you receive a 1099 that’s incorrect or isn’t yours, don’t simply discard it. Contact the company that issued the 1099 and have them report a corrected form to the IRS.
“Caution should be taken that all income is disclosed, such as unemployment, Social Security, pensions, and investment income,” says Camp. “Otherwise, you might as well send the IRS an engraved invitation to audit you.”
4. Too Many Deductions
The IRS will compare your itemized deductions to other taxpayers’ average total deductions for a particular item claimed by other taxpayers in their same income bracket as you. A taxpayer whose deductions seem to be more than these averages will be subjected to further investigation by the IRS. Don’t be shy about claiming all the deductions you qualify for – just be sure to have the right documents.
5. Schedule C filers
The IRS especially monitors companies that conduct business largely in cash, as well as companies that claim a loss. They also have a great deal of experience auditing self-employed individuals who underreport their income or overreport their expenses. You only need to ensure that your documentation backs what you are claiming.
“Any business that generates income is subject to scrutiny by the IRS,” says Ed Slott, a certified public accountant and founder of IRAHelp.com.
6. Holding Foreign Financial Assets
The IRS may investigate you further if it suspects that you have underreported foreign assets or income on your tax return, or if it suspects that you have foreign financial assets over $10,000 but have not filed a Foreign Bank Account Report (FBAR).
7. Having Neat, Round Numbers
Although neat, round figures that end in zeros, fives, or tens may be simpler to count and add aesthetic appeal to your company’s financial statements, they are a sign that financial data has been rounded or estimated. The IRS is more likely to start the auditing process if it observes that your payments and expenses don’t differ in value.
8. Home office deduction
Your home must be used exclusively or regularly for business in order to be qualified for the home office deduction. Ensure that home office expenditures are thoroughly verified and documented.
“A typical office-in-home deduction will be about 10% of the annual costs of running the home, but this will vary on square footage,” according to Camp.
9. Deducting Entertainment, Travel, and Meals Expenses
This is another category that raises IRS scrutiny due to prior abuse. Number one, it should go without saying that you can’t deduct expenses that your employer reimburses you for. Number two, you need to maintain detailed records – not a receipt, but a record of the people who were there, as well as the particular business purpose.
10. Making Transactions Involving Digital Assets
Non-fungible tokens and digital assets like Bitcoin continue to raise concerns for the IRS. Be ready to give documents for every transaction your company conducts with digital assets.
11. Earned Income Tax Credit (EITC)
The IRS approximates that 33% of EITC claims are made in error. While some mistakes are innocently made, the IRS examines EITC claims carefully to guard against fraud. If you are claiming the EITC, be certain to record how you qualify under EITC rules so that you can furnish this information to the IRS in the future, if necessary.
12. Early Retirement Account Withdrawals
These withdrawals have to satisfy specific requirements so them not to be taxed and penalized. As such, the IRS looks out for unreported early retirement account withdrawals that don’t satisfy the requirements and are thus taxed.
How Far Back Can the IRS Audit?
In typical situations, the IRS legally can look back three years when it comes to auditing tax returns. They can go further back if there are errors in a return, though they generally do not look any further back than six years.
The IRS has three years to audit you for extra taxes, but it can ask for an extension of that. (You aren’t obligated to take the extension.) And they must give you a refund if they owe you one within 3 years from the time of the audit.
How Many Years Should You Hold onto Tax Records?
Since the IRS can audit the tax returns of the last three years under normal circumstances, you should hold on to all tax returns and records for a minimum of three years. It is advised that some experts should be held for up to six or seven years, as the IRS may go beyond three years when auditing.
Note: Remember that if you don’t file a tax return, the IRS can audit you endlessly.
FAQs
What triggers an IRS audit?
If you fail to report all your income, then it can trigger an IRS audit. The main reason behind this is that the IRS relates your mentioned income compared to Forms K-1, W-2, 1099, etc.
How likely is it that the IRS will audit you?
Although the general rate for individuals is less than 1%, the probability of an IRS audit varies. High earners, particularly those earning over $1 million, are more likely to be audited, nevertheless.
How much money does the IRS consider a red flag?
The IRS would probably be suspicious of a taxpayer who earned tens of thousands more than the local median income.