What two words cause the most panic to Americans? There are probably a hundred funny responses running through your mind right now, but we were thinking of a less humorous response: "IRS audit."
Your odds of avoiding an audit are usually pretty good. The IRS reviewed 1.03 million tax returns in fiscal year (FY) 2016, resulting in a low audit rate of 0.7%. However, the latest annual report from the National Taxpayer Advocate has raised concerns that the IRS is publicly reporting misleading information and negatively impacting taxpayers' rights. Certain compliance processes such as math correction errors, identity and wage verification, and Automated Underreporter are not being included in the IRS definition of a "real" audit. As a result, taxpayers contacted through these procedures have less protection, including a limited ability to appeal an "unreal" audit's assessment. When these compliance processes are included, the audit coverage rate for FY 2016 jumps up to 6.2%.
There are some red flags that are likely to increase your odds of being audited. Some of these cannot be avoided, but others are essentially errors in judgment.
- You Are Wealthy – The IRS disproportionately audits wealthier Americans. Why? As the famous bank robber Willie Sutton allegedly said, "Because that's where the money is." Think of it as a return on investment of IRS time. As Betterment Head of Tax Eric Bronnenkant puts it, "The IRS audits wealthy people because they're the ones who are the most likely to get an adjustment out of it."
While there may be an element of ROI involved, there are also more benign reasons. Wealthier Americans have more potential deductions and tax shelters to claim and more complicated tax forms in general, thus it is reasonable that their forms receive more scrutiny.
Taxpayers with incomes over $10 million had a 17.4% chance of being audited (for "real"); $5 million draws a 9.6% chance of an audit (using 2016 statistics). You are least likely to be audited if your adjusted gross income is between $50,000 and $75,000 (0.4%).
- Low or No Reported Income – So much for the Willie Sutton theory. Low incomes receive more scrutiny to verify that the Earned Income Tax Credit is not being falsely claimed and that income is not being underreported. Over 6% of the taxpayers reporting no income in 2016 were audited by the IRS.
- Mismatching Income – Discrepancies between W-2/1099 forms and your reported income are easily picked up by the IRS computers. Make sure that all of your taxable income is reported and matches your forms.
- Disproportionate Charitable Contributions – Expect an audit if you made contributions that are out of line with your average income range, failed to file a Form 8283 with your larger donations, or made a one-off large contribution such as a donation of property to a charity.
- Home Office Deductions – The definition of a "home office" is stretched often enough that it tends to receive a closer examination. Make sure you meet the "exclusive and regular" business use requirement and be prepared to prove it.
- Calling a Hobby a Business – Continually unprofitable home businesses are likely to be considered as hobbies by the IRS (and really should be, if the business is truly unprofitable). The general rule is that the venture must earn a profit in three out of the five previous years to be truly considered a business.
- Holding Foreign Bank Accounts – Thanks to the Foreign Account Tax Compliance Act, overseas accounts require notifications to the Treasury Department and other paperwork depending on the size and nature of the accounts. Make sure all necessary paperwork is filed in a timely fashion – and even then, expect an audit if your account resides in a known tax haven.
- Excessive Business Deductions – IRS agents are quite adept at spotting sketchy business deductions where lines are blurred between personal and business expenses or the amounts seem excessive. Be prepared to defend all the business deductions you claim.
- Multiple Deduction Claims for Children – Divorced couples do not always agree on who should claim their children as dependents, and only one can do so. If the same child's Social Security number ends up on two different returns, guess what will happen?
The 2017 Tax Cuts and Jobs Act has brought about many changes. If you're uncertain as to how your tax return is affected, it's far better to consult a qualified tax professional than make a mistake that may invite an audit. Advises Bronnenkant, "I would only suggest that people prepare their taxes honestly and truthfully, and also be able to support what they put on their return in the event they get audited."
To any IRS agents who may be reading this article, we actually appreciate your service…and we were just kidding about the Willie Sutton remarks. Please don't audit us.
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