While there is no guaranteed escape from the potential of a randomized Internal Revenue Service (IRS) audit, there are a multitude of ways to attempt to avoid triggering one. Keep reading for 12 red flags IRS looks for when determining who to audit.
1. Having a higher than average income
Having a significantly above-average annual income has the potential to serve as a red flag for IRS to conduct an audit. IRS statistics show that those with an income between $200,000 and $1 million who filed a Schedule C in 2018 were audited at a rate of 1.4% compared to the overall 0.5% audit rate.
If your income increases by over $1 million, the chances of being faced with an audit also increase. Your best defense, as is the case with most of these common triggers, is to ensure that you maintain accurate documentation of all of your financial transactions.
2. Taking disproportionately large deductions
IRS uses undisclosed tables to determine the appropriate amount of deductions within each tax bracket. Since these thresholds are not publicly known, it’s important to be extremely careful not to claim unrealistically high deductions.
High deductions may be reasonable in some scenarios such as:
- Starting a new business
- Having a particularly tight year
- Large charitable donations
It rings bells for IRS, however, if your deductions are not reasonably proportionate to your annual income. Be as accurate as possible when claiming deductions.
3. Filing a Schedule C
A Schedule C form, also known as a “Profit or Loss from Business” form, is used by small businesses to report how much money they made or lost. It must be completed with your annual tax return if you made money from self-employment.
Schedule C allows sole proprietorships to take deductions that will lower their taxable income based on the amount that they made or lost in a given year. It is deduced that filing a Schedule C may increase the likelihood of being audited by IRS as it is true that they review these filings more closely than others.
4. Consistently claiming business losses
IRS will likely take notice if your business is reporting consistent losses year after year. They may assume that you’re claiming hobby expenses as business losses, which is illegal. A hobby is an activity completed for entertainment or pleasure, not for profit. Oppositely, a business is based on profit and is eligible for claimed losses.
If you are truly operating a business and still claiming losses each year, IRS may conclude that you’re purposely claiming losses to avoid paying taxes. There is, of course, always the option that your business is genuinely claiming losses for multiple years. Businesses may be struggling for one reason or another and have a legitimate reason for claiming losses.
5. Filing Late
In addition to late fees and penalties, filing your return late can solicit unwanted attention from IRS. When it comes to the agency, your best bet is to remain as under the radar as possible. Get in the habit of filing each year as early as possible. This might mean starting the process as early as January, but the advance preparation will be worth it to avoid any potential complications that could result from a late filing.
6. Deducting business expenses, travel, and entertainment
The benefit of filing a Schedule C form is being able to deduct business expenses for a sole proprietorship. This, however, can flag your business if your deductions for business expenses, travel, and entertainment are exceptionally high.
It’s important that when filing for any such deductions, you maintain specific records of all expenses. Without a clear record of exactly how much was spent on what, your deductions are unlikely to be accepted.
Additionally, the 2017 tax reform law eliminated the deduction for entertainment expenses. According to the updated IRS regulation, “Taxpayers may continue to deduct 50 percent of the cost of business meals if the taxpayer (or an employee of the taxpayer) is present and the food or beverages are not considered lavish or extravagant.” Since the update, IRS closely monitors deductions to ensure that companies aren’t deducting expenses for golf club memberships and tickets to sporting events.
One deduction type that has played a larger role in the past year than previously is home office deductions. With a huge portion of the American workforce transitioning to remote work as a result of the COVID-19 pandemic, we will likely see an increase in home office deductions. Businesses should ensure that these deductions are claimed properly because the complexity of their requirements is sure to bring scrutiny from IRS.
7. Rounding up or averaging income
Rounding numbers and totals here and there in everyday life might not be a big issue, but when it comes to your tax return, it’s not an option. If your annual income is $75,002.06, you should report it as such. Rounding down to $75,000 is likely to raise a red flag to IRS that the rest of your return information may not be fully accurate either.
8. Claiming your vehicle as 100% business use
There are two different ways to claim vehicle expenses on your return and it’s imperative that you choose one or the other. Claiming both, whether purposely or accidentally, is sure to bring IRS to your door. If you claim 100% business use of your vehicle, you’ll need to maintain records including mileage, dates, and the purpose of each business trip taken.
The two types of vehicle expenses are as follows:
Actual vehicle expenses method: Add up all vehicle operating expenses, including:
- Interest on your loan (or cost to lease a vehicle)
- Lease payments
- Registration fees
Divide any miles driven for business by the total miles driven. Finally, apply that percentage to your operating costs. This is your allowable deduction.
Simplified mileage expenses method: This method applies the current IRS-mandated mileage rate to the total miles driven for business in the year. In the 2019 tax year, the standard mileage deduction is $0.58 per mile of business use.
9. Having a large number of independent contractors compared to employees
This trigger has been especially prominent due to recent changes brought on by the proposition of both Assembly Bill 5 (AB-5) and Proposition 22. When determining how your business classifies your workers, it’s critical that you do so in a way that follows official guidelines. Failing to do so has the potential to trigger an audit of your business involving both IRS and the Employment Development Department (EDD).
This flag may be identified in any number of ways. Audits may be triggered by the following:
- An independent contractor filing for unemployment or workers’ compensation (to which they do not pay into as 1099s)
- A worker may directly report you to EDD or IRS
- You may be identified as incorrectly classifying workers if you have an unrealistic ratio of contractors to employees.
If your business is bringing in a significant amount of annual income, but only has a handful of employees on your payroll, it may bring up the question of who is working for and running your business. If EDD or IRS dig into the matter further and determine that a majority of your business’ labor is coming from 1099 workers, they may consider that grounds to look into the matter further through an audit.
10. Large cash transactions
Another way that IRS may be triggered to audit your business is if you have a significantly large amount of cash transactions. All cash transactions over $10,000 must be declared by filing Form 8300. IRS recognizes that cash transactions are more challenging to accurately track than credit card or electronic transitions such as PayPal.
Filing Form 8300 is IRS’s way to avoid and limit the potential threat of money laundering in an effort to conceal illegal activity such as drug trafficking, tax evasion, and terrorist financing.
11. Foreign Earned Income Exclusion Claims
United States citizens are only eligible to claim a foreign earned income exclusion if and only if they have a foreign earned income, the tax home is in a foreign country and they meet at least one of the following:
- Are a bona fide resident of a foreign country for an entire tax year
- Have an income tax treaty for the whole tax year
- Are citizens who reside in a foreign country or countries for at least 330 full days for one year straight
For 2022, foreign earnings are eligible for exclusion up to $112,000. Businesses with weak ties to foreign countries they partner or work in or keep the majority of their business on U.S. territory can flag an IRS audit. The agency actively monitors foreign earned income exclusion claims to ensure filers meet the strict criteria.
12. Using Virtual Currency Transactions
In May 2021, the Treasury Department implemented regulations that cryptocurrency transfers of $10,000 or more must be reported to IRS. The agency suspects large sums of traded money are traded under the radar of the government. In order to catch fraudulent activity of unreported income through virtual currency, IRS has begun sending letters of intent to people they suspect have virtual currency accounts.
Regardless of your business type, everyone is at risk of being audited by IRS. Do your best to avoid an audit by educating yourself on the most common red flags that point IRS spotlights straight towards your business. That being said, even if you follow every rule to a T and do everything within your power to file properly, there’s still the possibility of an audit. For more information about IRS audits, read our article that answers the 7 most common questions about IRS audits.