Avoid an Audit by Knowing These 6 Red Flags

If history is any indicator, fewer than 1% of Americans will be audited by the Internal Revenue Service (IRS) in the coming year.1 Of that small amount, some of the audits are totally random. But many are triggered by actions taxpayers themselves have taken.

Below is a list of red flags that can cause your tax return to be targeted by the IRS for review. Pay particular attention, as knowing what these triggers are can save you a lot of trouble and anxiety.

KEY TAKEAWAYS

• Overvaluing home office expenses and donated goods are red flags to auditors.
• Simple math mistakes and failing to sign your tax return can also trigger audits.
• The odds of an audit increase with six-figure incomes, but under-reporting your earnings is ill-advised.
• Small business owners and limited partnership participants are at greater risk of being audited.
  

#1. Overestimating Donated Amounts

The IRS encourages individuals to donate things like clothes, food, and even used cars to charities. It does this by offering a deduction in return for a donation. The problem is that it is up to the taxpayer to determine the value of goods that are donated.

As a general rule, the IRS likes to see individuals value the items they donate anywhere between 1% and 30% of the original purchase price (unless special circumstances exist).2 3 Unfortunately many, if not most, taxpayers either aren't aware of this or simply choose to ignore this fact.

There are several other tips that the taxpayer can use to ensure that they are valuing donated goods at a "fair" price. Consider having an appraiser write a letter, naming in his or her considered opinion the worth of the item. In fact, for individual items valued at $5,000 or more, an appraisal is required.4

Another benchmark the IRS uses that could come in handy is the willing-buyer-willing-seller test. This means that taxpayers should value their goods at a point or price where a willing seller (who is under no duress) would be able to sell his property to a willing buyer (who also is under no duress to purchase the item).5 Using such a benchmark will keep you out of trouble and prevent you from placing excessive value on items donated to charity.

#2. Math Errors

While this may sound simple, many returns are selected for audit due to basic mathematical mistakes! So when filling out your tax return (or checking it after your accountant has completed the form) make sure that the columns add up. Also, make sure that the total dollar value of capital gains and/or losses are properly calculated. Even a small error can set IRS alarm bells ringing.

#3. Failing to Sign the Return

A surprisingly large number of people simply forget to sign their tax returns. Don't be a part of this group. Failure to sign the return will almost guarantee additional scrutiny. The IRS will wonder what else you might have forgotten to include in the return.

#4. Under-Reporting Income

Tempting as it might be to exclude income from your tax return, it is vital that you report all monies that you received throughout the year from work and/or from the sale of an asset (such as a home) to the IRS. If you fail to report income and get caught, you will be forced to pay back-taxes plus penalties and interest.6

How can the IRS tell if you've reported everything? In some situations, it can't. After all, the system isn't perfect. However, a common way some individuals get caught is that they accept cash for a service they've performed. If the customer or individual who paid that individual the cash gets audited, the IRS will see a large cash disbursement from his or her bank account. The IRS agent will then follow that lead and ask the individual what that cash layout was for. Inevitably, the trail leads right back to the individual who failed to report that money as income.

In short, it's better to be safe than sorry. Make sure you report all of your income.

#5. Overdoing Home Office Deductions

Be careful with home office deductions. Taking off an excessive or unwarranted amount (like all of your monthly rent) can raise red flags. Be modest in determining the amount of space you use for work, and the expenses associated with it.

Deductions that are too large in proportion to your income can raise the ire of the IRS as well. For example, if you earned $50,000 as an accountant (operating out of your house), home-office related deductions totaling $30,000 will raise more than a few eyebrows. Trying to write off the value of a new bedroom set as office equipment could also draw unwanted attention.

In short, deduct only items that really were used in the course of your business.7

#6. Income Thresholds

There is nothing the individual taxpayer can do about this one, but if you earn more than $100,000 each year, your odds of being audited increase exponentially. In fact, some accountants put the odds of being audited at one in 72, compared to the one in 154 odds for people with lower incomes. Tempting as it may be, don't try any questionable moves just to get your income out of five figures, though.

Who is Most at Risk for an Audit?

Some situations tend to attract the IRS' attention more than others.

Partnership/Trust/Tax Shelter Risk

If you own shares in a limited partnership, control a trust, or make any other tax shelter investments, you are more likely to be audited. It isn't necessarily a given thing, but individuals who have a stake in such an entity should be aware that they face a higher likelihood of scrutiny. They should also take even greater care to document their deductions, donations, and income.

Small Business Ownership

Small business owners are an easy target—particularly those with cash businesses. Bars, restaurants, car washes, and hair salons are exceptionally big targets, not only because they deal in so much cash, but also because there is so much temptation to under-report income and tips earned.

Incidentally, other actions that are commonplace with business ownership may draw unwanted IRS interest, too, including putting family members on the payroll and overestimating expenses.

In short, business owners must know that they can't "push the envelope." If they want to stay in business and avoid the scrutiny of an audit, it's best to remain on the straight and narrow.

So why does the IRS seem to be cracking down more and more on individuals and small business owners these days? It's simple. According to a September 2019 IRS report, roughly an annual $381 billion gap exists between what Americans pay in taxes versus what they owe.8 That equates to about $2,080 per household. The Congress knows this too, and given the deficits the United States government has run up over the past 20 years, there is enormous pressure on legislators and the IRS to collect taxes owed.

Getting Audited

What should you do if you are audited? Be honest with the auditor and respond to all inquiries as quickly as possible. Don't be afraid to show all of your documentation. If possible, have a qualified accountant and/or tax attorney represent you.

The Bottom Line

The IRS will continue to use audits as a tool to increase collections, but that doesn't mean that you have to be among the lucky few to be chosen. The key to avoiding an audit is, to be accurate, honest, and modest. Be sure your sums tally with any reported income, earned or unearned—remember, a copy of your earnings is being furnished to the IRS, as the forms say. And be sure to document your deductions and donations as if someone were going to scrutinize them. Because someone just might.

Article Sources:

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1. Internal Revenue Service. "Enforcement: Examinations."
2. Goodwill. "Donation Value Guide -- What Is my Donation Worth?"
3. Internal Revenue Service. "Publication 561: Determining the Value of Donated Properties," Page 4.
4. Internal Revenue Service. "Publication 561: Determining the Value of Donated Property," Page 8.
5. Internal Revenue Service. "Publication 561: Determining the Value of Donated Property," Page 2.
6. Internal Revenue Service. "Under-Reporting Income."
7. Internal Revenue Service. "Publication 587: Business Use of Your Home," Page 4.
8. Internal Revenue Service. "Tax Gap Estimates for Tax Years 2011–2013."