IRS Audit: Reasons why you may be audited
The thought of being audited reminds me of movies where the official comes into the corporation, and people are handcuffed the next thing you know. But the truth is that not all audits happen in your office or physically, and being audited doesn’t mean you’re going to prison. The agency randomly selects tax returns for different reasons.
What is an IRS Audit?
An IRS audit involves a detailed inspection of your financial records and transactions. The purpose is to verify that your tax filings are accurate and compliant with tax regulations. The IRS is trying to confirm that your returns are correct, and if you aren’t cheating the system, there’s nothing to fear.
Why does the IRS audit?
The reason for audits is to try to reduce the “tax gap,” which is the difference between what the IRS is owed and what it receives.
Where does an audit occur:
If you are selected for a tax audit, the IRS will send you a letter about it. This audit might take place entirely through mail correspondence or involve an in-person interview at an IRS office, your home, your tax preparer’s office, or your place of business. During the audit, the IRS may request specific documents to review your case thoroughly. That’s why the IRS advises keeping your tax records for at least three years after filing. However, in some cases, they might audit returns from up to six years ago.
Once the audit concludes, the examiner will either confirm that your return doesn’t need any changes, suggest some adjustments, and potentially issue a bill related to the findings. If you disagree with the examiner’s decision, you have options: you can discuss it with an IRS manager, seek mediation, or file an appeal.
How does the IRS audit?
The agency uses specialized software to analyze each tax return compared to others within the same income bracket. This process assigns a score to each return, where the higher the score, the greater the likelihood of being selected for an audit.
Common Audit Triggers
Other ways could get you on the audit list if you’re not flagged by the system or randomly selected.
1. Third party involvement:
The IRS might audit you because your tax returns involve transactions with a tax return being audited, like the returns of a business partner or an investor.
2. Large change in income:
Significant changes in your income from one year to the next can often catch the attention of the IRS. It’s understandable that life can throw curveballs – maybe you lost your job or had a sudden financial windfall.
These ups and downs in earnings are a part of life, and usually, someone can easily explain them. However, the IRS might get curious when your income shows big jumps or drops, and there’s no apparent reason for it (like a job loss, which should reflect on a W2).
They start thinking that you have probably omitted some income. So, they’ll take a closer look, comparing your income over several years and the documents you’ve provided, to see if everything adds up.
3. Virtual Currency and Cryptocurrency Transactions:
The IRS has identified virtual currency fraud as a top priority and partnered with financial and cybercrime investigation units to search for unreported or improperly reported virtual currency-related income. While early virtual currency investors may have utilized the IRS’ incompetence to their benefit, it is improbable that such methods will continue to be successful.
The IRS will ask for your wallet ID and blockchain addresses to gather detailed information about virtual currency transactions. You may ask yourself, “If the IRS audits my virtual currency tax returns, can they also audit my non-virtual currency income?”
Given the ambiguous nature of regulations surrounding the taxation of cryptocurrency and NFTs, it is doubtful that improperly filed virtual currency tax returns correlate with improperly filed income taxes.
At this stage, the IRS wants to enforce virtual currency taxation compliance.
4. Errors with your math:
Try as much as possible only to use accurate records of your transactions; don’t try to change figures or round up to the nearest hundred dollars: $256.36 to $260 or even $300. It’s better to round up to $257 or, better still, $256.
Mistakes are bound to happen and, if found, attract fines regardless of whether they are intentional or unintentional. That’s why I advise you to triple-check all your numbers if you’re handling your taxes or outsourcing your tax filing to us.
5. Claiming a large number of charity donations:
Claiming deductions due to charitable donations is an intelligent way to reduce your tax bill. Still, you should be careful when going down this route, especially if you didn’t make any contributions or can’t prove them.
Imagine someone who claimed to make donations of $5,000 while they earned $15,000. This is sure to raise some eyebrows and can, in most cases, prompt an audit.
6. Not reporting all income:
One of the easiest ways to bag an IRS audit is by not reporting all your sources of income. You might think that side-gigs don’t count and be tempted to submit your w-2 form only, but one thing you must remember is that your side-gig employer would also send in their returns, and you’ll get caught sooner or later.
Ensure you file Form 1099-NEC for contract work or Form 1099-B for investment earnings.
7. Reporting too many losses on your Schedule C:
For self-employed people, it’s essential to be cautious about how you report expenses. Have you considered classifying personal expenses as business ones to reduce taxable income? Be careful – listing things like a new pair of sneakers as a business expense might raise some eyebrows at the IRS.
Also, excessive reported losses can lead them to question how your business stays in operation with all the losses you’re recording. To ensure clarity, it’s a good idea to check out IRS Publication 535, which provides clear guidelines on what qualifies as a legitimate business expense.
8. Recording too many business expenses:
Similar to reporting too many losses is reporting too many expenses. An expense must be ordinary and necessary to your business to be eligible for deductions. The first thing to ask yourself is, is this a common purchase or expense in your line of business? And does this expense help my business?
9. Using round even numbers:
Round numbers are a straightforward way to show that you’re making up the figures or guessing.
Likely, the figures on your 1040 form and other tax documents won’t neatly round up to intervals of $100. So, when calculating your numbers, aim for precision and steer clear of rough estimates. Being exact in your calculations is critical.
10. Not reporting your foreign accounts:
Under the Foreign Account Tax Compliance Act rules, if you have foreign bank accounts with assets totaling $10,000 or more, the IRS mandates that you report these on Form 8938. Failing to report such accounts could lead to extra scrutiny of your tax return. However, it’s worth noting that reporting these foreign accounts can also draw attention, as it suggests the possibility of having assets overseas.
Conclusion
While we can’t say precisely how the IRS selects individuals for an audit, these triggers listed above have a very high tendency to get you on the IRS audit list.
If you need any help with your taxes this year, contact us or set up a free 15-minute call with me.