Advice | Fear an IRS audit? Here are six alarms that trigger the system. (2024)

Or maybe you run a small printing business and your return shows extravagant meal, travel and entertainment deductions. You could find yourself facing an audit.

Here’s the thing: If you have a right to take a deduction, claim it. But you better have the documentation to prove it.

Audit fearmongering is all the rage among many congressional Republicans unhappy about the funding boost the IRS secured thanks to the Inflation Reduction Act. Part of the money is being spent on beefing up tax enforcement. However, the goal isn’t to terrorize people trying their best to file accurate returns. The agency is looking for tax compliance, which can lead to cases against individuals and businesses that are intentionally trying to avoid their tax obligations.

For the most part, if you get audited, it’s not a personal attack on your integrity. Rather, the IRS’s automated system has spotted something that doesn’t appear right. In fact, read IRS Publication 556 (Examination of Returns, Appeal Rights, and Claims for Refund) and you’ll see that the agency says it accepts most federal tax returns as filed, no questions asked.

But, as the agency points out: “If your return is selected for examination, it does not suggest that you made an error or are dishonest. Returns are chosen by computerized screening, by random sample, or by an income document matching program.”

A return can be selected for an audit based on a computer score that assigns a numeric value to each individual and some corporate tax returns after they have been processed, according to the IRS.

But this is one test where you don’t want a high score, because it could cost you. So let’s examine six common red flags for an audit.

The more you earn, the higher the likelihood of an audit.

“Although audit rates decreased more for higher-income taxpayers, IRS generally audited them at higher rates compared to lower-income taxpayers,” according to a 2022 report by the Government Accountability Office.

Based on 2019 returns, 1.3 percent of taxpayers earning $1 million to $5 million were audited, according to the latest IRS data. Audits for taxpayers earning more than $10 million reached close to 9 percent. That’s compared with 0.2 percent for taxpayers earning $25,000 to $50,000. Interestingly, that was the same audit rate for taxpayers with income ranging from $200,000 to $500,000.

In a statement last year about the audit rate, the agency said it was “taking steps toward addressing high-end noncompliance.”

“Field Revenue Agents are focused on high-income individuals and their related entities and, to a lesser degree, large corporate and complex pass-through entities,” the IRS said.

It is important to note that lower-income taxpayers claiming the earned-income tax credit generally have a higher-than-average audit rate, the GAO report said.

“The EITC audit rates can be higher than audit rates for some higher-income taxpayers because EITC audits are limited in scope and less time consuming, allowing IRS to conduct more audits,” the GAO said.

The IRS compares what it receives on documents such as W-2s or 1099s with what you report on your tax return. You might get a letter that was generated as part of the agency’s “automated underreporter” program, which issues notices if it appears you haven’t reported all income. When a discrepancy is found, the IRS sends you a proposal to adjust your return. How you respond could result in additional taxes owed or possibly a refund.

The IRS closed nearly 2.4 million cases under the automated underreporter program in fiscal 2021, resulting in nearly $10.3 billion in additional tax assessments.

Substantially understating your income could result in a pretty severe penalty. The IRS has the authority to hit filers with an accuracy-related penalty equal to 20 percent of their underpayment of taxes.

Under the American Rescue Plan Act, there’s a new reporting rule for Form 1099-K. Starting next year, the IRS will require all third-party payment processors to report payments received for goods and services of $600 or more a year.

You can still use the payment applications to split a restaurant check with friends or send birthday money to relatives without triggering a tax bill. The reporting rule change is intended to help the IRS track income received, not the exchange of funds between family and friends.

If you receive an IRS CP2000 notice generated by the automated underreporter program, respond right away, because it could be an error.

Wondering why your return is selected for review? “Sometimes returns are selected based solely on a statistical formula,” the IRS says. “We compare your tax return against ‘norms’ for similar returns.”

If the deduction is legit, take it. But large deductions that seem out of line for your income or business can be a red flag.

For instance, if you have a home-based business, claim every legitimate deduction, even if it might increase your odds of an audit. Just be prepared to prove you meet all the deduction requirements.

Changes made under the 2017 Tax Cuts and Jobs Act mean it’s crucial to know the difference between a hobby and a legitimate profit-making enterprise.

Before, you could claim hobby expenses — up to the income it generated — as part of the class of miscellaneous itemized deductions that needed to exceed 2 percent of adjusted gross income. However, starting in 2018 and until 2025, these types of deductions are no longer allowed.

I’ve been at seminars where “experts” have openly encouraged people to use a business as a tax shelter.

“If you do not carry on your business or investment activity to make a profit, you cannot use a loss from the activity to offset other income,” the agency says in the publication.