The last place you want to find yourself is in the Internal Revenue Service’s crosshairs.
In a tax audit, the IRS puts your entire financial life under the microscope – your income, your assets, and your expenses. And if you fail to prove to their satisfaction that your return was accurate, prepare for penalties, fines, or even jail time.
But most IRS audits are not random. They’re triggered by algorithmic “red flags” that statistically indicate either a faulty return, high odds of undisclosed income, or both. Some of the better online tax preparation services, such as H&R Block, now include alerts if your return includes the red flags below, although there’s no substitute for hiring a certified tax preparer to ensure your return is complete and accurate.
Red Flags to Watch for on Your Tax Return
Avoid these 11 audit triggers when preparing your return to prevent unwanted attention from good ol’ Uncle Sam.
1. High Earnings
According to the most recent available data, the IRS audited 0.6% of all tax returns between 2010 and 2018, or around 1 out of every 167 returns. But the higher the income reported, the higher the odds of an audit.
Taxpayers earning over $1 million in income saw their audit rates quadruple the average. Why? Because that’s where the best bang for the IRS’s buck lies. If they catch a mogul who earns $10,000,000 per year cheating on their taxes, they can potentially reel in millions of dollars in unpaid taxes.
But if they catch Joe Bartender underreporting his tips by $500, the IRS isn’t exactly sitting on a goldmine of uncollected revenue.
As your income rises, prepare for extra scrutiny from the IRS, especially if it rises fast.
2. Undeclared Income
If you do work for someone, whether as a W2 employee or a 1099 contracted worker, the IRS probably knows about it.
When you fail to declare taxable income, but the IRS receives documentation that you received it, you can expect to hear from them.
Even when you earn cash income and the payer files no 1099, the IRS still uses algorithms to check your spending habits against your declared income. When they don’t align, you can expect to get audited.
3. High Deductions Relative to Income
If you earn $95,000 from your job but claim $90,000 in tax deductions, you better believe the IRS will raise their humorless eyebrows.
For some expenses, such as the mortgage interest deduction, lenders file a 1098 tax form with the IRS. They know exactly how much you spent on mortgage interest, so don’t even think about inflating the number.
And for other deductible expenses, such as charitable donations and education costs, the IRS flags your return if they’re high relative to your income. Do yourself a favor and keep your deductions reasonable relative to your income, especially oft-abused deductions like the home office deduction.
Confident in the legality of your deductions? Take them, but keep excellent records, because you may have to prove their validity to the IRS.
4. Inflated Business Expenses
For self-employed taxpayers like freelancers and small-business owners, deducting business expenses on Schedule C is a dream. These filers can still take the standard deduction, but they also get to deduct a slew of expenses – travel, a home office, and office supplies are a few examples.
Best of all, business expenses deducted here reduce not only their income tax bill but also their self-employment tax bill.
And the IRS knows it. Before you get too expense-happy, here are a few faux pas to avoid.
Claiming More Deductions Than Profits (Especially for Multiple Years)
Most businesses lose money in their first year or two. It takes money to start a business after all, and few businesses see an immediate profit. But the more expenses you claim relative to your business income, the greater the odds of an audit, especially when you claim business losses several tax years in a row.
Reporting Round Numbers for Income or Expenses
Business is messy. So when the IRS sees neat, tidy round numbers, they know the taxpayer probably rounded them, which means an estimate at best, and an invention at worst. In turn, that means the taxpayer likely can’t produce accurate documentation for these too-perfect round numbers.
Writing Off 100% of Common Personal Expenses
What are the odds that a taxpayer only uses their smartphone for business, and has an entirely separate phone for their personal life? Or how about separate cars that only get driven for business?
Few people wander around with multiple phones in their pocket or purse. And few people keep one car exclusively for work, and one solely for personal use. Unless you can prove you’re the exception, don’t claim 100% of your phone, car, or other expenses that you sometimes use in your personal life.
Deducting Too Much for Meals, Travel, and Entertainment
Taxpayers find it all too tempting to write off meals, travel, and entertainment costs as business expenses. Sure, sometimes self-employed people do incur these expenses. But get too greedy, and the IRS will come knocking. They know this unholy trinity of expenses gets abused, just as they know that it’s difficult for taxpayers to prove that 100% of a trip’s expenses were business-related.
Also, under the Tax Cuts and Jobs Act of 2017, business owners can no longer deduct entertainment expenses at all. This means no more golf deductions or sporting event deductions, regardless of how much business you discuss on the links.
Take meal and travel deductions conservatively, if at all, and keep detailed records and receipts. If you don’t have records of who was there, what you talked about, and why it was business-related, don’t deduct the expense.
Taking Too Many Home Office Deductions
Self-employed people can still claim a home office deduction, unlike employees. But the IRS knows how many taxpayers abuse this self-employment tax deduction, making for easy auditing.
The rules are clear: You can only deduct for space in your home that is exclusively for business use. It doesn’t matter how many work emails you answer while sitting on your living room couch watching Netflix. You can’t deduct for that space.
If you have an actual office in your home you use only for business purposes, you can deduct for it. If the first floor of your home is a public business, such as a bar or hair salon, and you live in the second-floor apartment, you can deduct for the first floor. Otherwise, don’t get cute and try to claim your guest bedroom that has a desk in one corner.
As a final thought, you can only take the home office deduction if you report profits. It can’t be used to expand reported losses.
5. Foreign Financial Accounts
The IRS gets extremely curious about foreign assets. They know many tax evaders use offshore pirate banks and tax havens, and once they catch the scent of foreign assets, they release the hounds for the hunt.
If you keep foreign financial accounts that totaled more than $10,000 combined at any time during the year, you must file a FinCEN Report 114 (FBAR). Failing to do so can lead to vicious penalties.
And while the IRS is more likely to audit taxpayers with disclosed foreign bank accounts, what really gets the dogs barking is when they discover undisclosed foreign accounts. In short, be very careful with your foreign assets.
6. Cash-Heavy Businesses
Restaurants, bars, barbershops, nail salons, car washes, and other cash-only or cash-heavy businesses are primed for audits by the IRS. Why? Because the IRS knows that cash-heavy businesses can more easily underreport revenues.
Cash-heavy businesses make for doubly enticing audits because they are so often used for money laundering.
If you operate a cash-heavy business, keep squeaky clean books, and hire a sharp accountant.
7. Claiming the Same Dependent Twice
Only one parent can claim a child as a dependent.
If you’re married but file separately or are divorced, that means one parent is out of luck on their return. If need be, use the tie-breaker rule found in IRS Publication 501.
Unlike many of the other red flags on this list, this tax return misstep is usually just that: a mistake. But don’t make it, because claiming the same dependent twice will flag your return as erroneous with the IRS.
8. Claiming Rental Losses
Among the many advantages of real estate investing is the tax benefits. But if you claim losses from a rental property, be prepared to back up your numbers.
The IRS allows up to $25,000 in rental losses to be deducted against your regular W2 income – if you actively manage your rental properties yourself. If you outsource to a property manager, forget about it.
Even if you self-manage, the deduction phases out for taxpayers earning over $100,000, and it disappears entirely for those earning $150,000 or more.
Owning rental properties complicates your tax return, as these nuances are merely a scratch on the surface of the rules. Hire an accountant familiar with real estate investments to maximize your deductions, and to keep yourself out of Uncle Sam’s crosshairs.
9. Claiming Losses for a Hobby
Hobby expenses aren’t tax-deductible. Period.
To qualify as an actual business with deductible expenses, the activity must have a reasonable expectation of earning a profit and must be managed in a business-like manner. If you earn money primarily from a W2 job or other sources and try to claim “business” losses for several years in a row, it often flags your return for a human agent to review. And when they see a “business” that sounds suspiciously like a hobby, expect a visit.
Of course, no one says you can’t turn your hobby into a money-making business. Just make sure you do so before you start claiming expenses.
10. Taking Early Distributions From an IRA or 401(k)
When you withdraw money from your retirement account before age 59½, it counts as a distribution and is subject to a 10% penalty, plus unpaid taxes due. Many taxpayers neglect to pay that penalty – and hear from the IRS about it.
Your plan custodian reports all retirement account distributions to the IRS, so the IRS already knows about it. When you fail to declare something the IRS already knows about, you can guess what happens.
Avoid the issue altogether if you can, and only touch your retirement savings after you retire.
Pro tip: If you have access to an employer-sponsored 401(k) plan, make sure you sign up for Blooom. They’ll do a free analysis of your account to make sure you’re properly diversified, have the right asset allocation, and aren’t paying too much in fees.
11. Failing to Report Gambling Winnings
Many recreational gamblers don’t know that casinos report to the IRS, using Form W-2G. Once again, Uncle Sam knows more than you think he does, and when the casino reports a big win on your part, and you neglect to disclose it, you can expect an audit.
Recreational gamblers must disclose any winnings as “other income” on their Form 1040. Professional gamblers must declare their income on Schedule C.
But where gamblers really get into trouble is reporting losses. By law, gambling losses can only be used to offset gambling winnings, not other types of income. The only exception is made for professional gamblers, and if you try to claim that you’re a professional gambler with losses on your Schedule C while earning a full-time W2 salary, expect scrutiny.
U.S. tax laws leave so much room for interpretation that it often takes a judgment call. As your tax return gets fatter and more complicated, one of the financial advisors you should hire is an accountant.
Sometimes you want someone to tell you not just what you can do, but what you should do. Sure, you may be able to massage an expense into a deduction, but at what cost in terms of audit risk?
Any time your tax return includes one or more of the red flags above, be extra careful to keep meticulous records and hire a tax professional if needed. The taxman may well come for you.