Provided by Nathan Cacka, CPA, Cordell, Neher & Company, Wenatchee Certified Public Accountant

Though the fear of an audit is great, the risk is actually extremely low. Fewer than 1% of Americans have their Federal taxes audited. In fact, the percentage has been declining recently due to Internal Revenue Service budget cuts. In 2016, just 0.7% of individual returns were audited (1 of every 143). That compares to 1.1% of individual returns in 2010.1,2

Now that we know that the chances of being audited are low, the question becomes, what are some “red flags” that will increase the chances of your return being part of the “chosen few”.

The wealthy and lower-income taxpayers are more likely to be audited. This is because an audit of a wealthy taxpayer could result in a “big win” for the IRS. With lower incomes, the IRS simply cannot dismiss returns that claim implausibly large credits and deductions. Data compiled by Tax Foundation, a non-profit, provides the graph below, which clearly illustrates the spread of the 2015 IRS Audits.2

Abnormally large deductions could give the IRS pause. The IRS uses computerized analytical tools to determine if deductions are outside the norm. For example, suppose that you earned $95,000 in 2016 while claiming a $15,000 charitable deduction. Forbes estimates that the average charitable deduction for such a taxpayer last year was $3,529.3

Even the type of deduction can cause suspicion. For instance:

  • Taking the Earned Income Tax Credit (EITC) without any adjusted gross income
  • Claiming a business expense for a service or good that seems irrelevant to your line of work
  • A home office deduction, if the “office” amounts to a room in your house that serves other purposes 4
  • Claiming 100% business use of an automobile, when there is no other vehicle available for personal use
  • Excessive mileage deductions in comparison to similar tax filer data

Claiming an alimony deduction increases focus by the IRS. The rules on deducting alimony are complicated, and the IRS knows that some filers who claim this write-off do not satisfy the requirements. Mismatching between the payer and the recipient on their respective returns will almost certainly trigger an audit or at least an IRS notice. This will become even more complicated with the Tax Reform passed at the end of 2017 with regard to alimony.

Self-employment can increase your audit potential. For example, in 2015 taxpayers who filed a Schedule C listing business income of $25,000-$100,000 had a 2.4% chance of being audited.2

Continuous years of business losses may result in further inquiry by the IRS. Several years of Schedule C or F business losses from an activity that appears to the IRS to be a hobby can wave a red flag. To determine if you have a hobby or a business, ask yourself: is there a profit motive or expectation central to the activity (business), or is it simply a pastime offering an occasional chance for financial gain (hobby)?

Failure to take a Required Minimum Distributions (RMDs) will draw scrutiny as well. The IRS does watch RMDs closely. Retirees who neglect to withdraw required amounts from IRAs and employer-sponsored retirement plans can be subject to a penalty equal to 50% of the amount not withdrawn on time.1

Foreign activity may raise attention. Failure to report financial interest or signature authority over foreign financial accounts with a combined total of more than $10,000 at any time during the year will cause your return to be investigated. The IRS is intensely interested in people with money stashed outside the US, especially in countries with the reputation of being tax havens.

Finally, the fastest way to invite an audit might be to file a paper return. The error rate on hard copy returns is substantially higher than electronically filed returns. So, if you still drop your 1040 Form off at the post office each year, you may want to try e-filing in the future.4 

Nathan Cacka is a Certified Public Accountant with Cordell, Neher & Company, PLLC, a Wenatchee public accounting firm. Nathan may be reached at 509-663-1661 or nathan@cnccpa.com.

www.cnccpa.com

Citations.

  1. kiplinger.com/slideshow/retirement/T056-S011-9-irs-audit-red-flags-for-retirees/index.html [3/17]
  2. fool.com/retirement/2017/02/06/here-are-the-odds-of-an-irs-audit.aspx [2/6/17]
  3. forbes.com/sites/baldwin/2017/01/23/tax-guide-deductions-and-audit-risk/ [1/23/17]
  4. fool.com/retirement/2016/12/19/9-tax-audit-red-flags-for-the-irs.aspx [12/19/16]
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