Recently, The Kiplinger Tax Letter published on its website “15 Audit Red Flags.” I set them out below – some verbatim and some paraphrased. The snarky comments are mine.
- Making a lot of money. If your income is $200,000 or more, you must be doing something bad: you are three times as likely to be audited by the IRS as people making less than $200,000.
- Not reporting what is on information returns sent to the IRS. The IRS is pretty darn good at tracing information returns like W-2s and 1099s to tax returns.
- Claiming high itemized deductions. If you really paid them, deduct them. However, be ready to show proof to the IRS.
- Having a Schedule C for a business that shows a loss. IRS: Gold mine!
- Reporting large charitable deductions. Be ready to produce your cancelled checks (who has them anymore?) or credit card statements and the acknowledgements from the charitable organizations. Big property contributions? Be sure to follow all the IRS rules about appraisals and Form 8283 reporting; there is no room for error.
- Claiming rental losses. Net rental losses can only be claimed by an individual above a certain income level who qualifies as a real estate professional. Are you a part-time landlord? Chances are you can’t deduct your net rental losses. Passive income from other sources (known as “PIGs” to us tax nerds) to offset the rental losses would help.
- Taking an alimony deduction. You must obey very precise rules to deduct alimony. The IRS knows this. Wise family law attorney Mrs. Maultsby knows this. The IRS surmises that you may not.
- Writing off a loss for a hobby activity. There’s no form that says “here is a nondeductible hobby loss.” The IRS looks for some other indicators. See item 4 above. Have a Schedule F (reporting farm income or loss) showing a negative number at the bottom of the form.
- Deducting big business meals, travel and entertainment deductions. If you incur more entertainment expenses than the average IRS agent, you are suspect.
- Failing to report a foreign bank account. Dumb, dumb, dumb. The IRS has information exchange arrangements with a number of countries and gets the information directly from many foreign financial institutions, too. The penalties for not reporting can be more than the money in the account.
- Claiming 100% business use of a vehicle. OK, if the vehicle is a front-end loader or backhoe. Otherwise, the IRS (pretty much rightfully so) does not believe that a vehicle is ever used 100% for business. Pick up the kids from school occasionally? Loan your vehicle to your spouse, when said spouse’s vehicle is in the shop. Go a block or two out of your way to pick up your spouse’s dry cleaning? Get my point?
- Showing Day-Trading Losses on Schedule C. Day traders generally get better tax treatment than investors who trade frequently. I’ve day-traded or traded frequently some in the past. Spent a lot of time and money to set up my trading. Traded a lot. I never reached the level of activity necessary to convince the IRS (and the courts) that I should be entitled to day trader status. Maybe if you traded all day and every day that the market is open, you have a shot at day trader status.
- Gambling. You have better chances drawing to an inside straight than you have successfully claiming losses as a professional gambler. Win big and don’t report your winnings? See item 2 above.
- Claiming a home office deduction. Generally, you must use the space exclusively and regularly as your principal place of business. Notice all the limiting modifiers in the previous sentence? Also, you get the deduction by filling out a schedule for “business use of home.” Might as well wear a sign that says “kick me”!
- Cash. Big deposits and withdrawals of cash attract the IRS’ attention. So do big purchases for cash. How does the IRS find out? A number of businesses and financial institutions must report suspicious activities.