Ten Profile Issues That Can Lead To IRS Audits
- High Income – The higher the income is on the return, the higher the rate bracket the taxpayer is in. High income profiles therefore receive more scrutiny in processing, because the IRS return on investment if they determine additional tax liability is greater than for a profile that is more middle class.
- Under-reporting Income – IRS receives data from payor sources of taxpayer income on forms 1099, K-1, and W-2s. The IRS has developed and continues to improve its computer matching programs. If income, or potential income has not been reported on your return, you are likely to receive a correspondence CP2000 audit letter. Payments received for mortgage interest, tuitions, and IRA contributions are also reported and matched. If deductions claimed exceed amounts reported to IRS, an inquiry is possible.
- Charitable Contributions – The rules for substantiation of donations to charities are very strict. IRS can disallow any deduction claimed for a donation of $250 or more that does not meet the substantiation requirements. Thus, higher contribution deductions can draw more scrutiny if the amount claimed is out of line with IRS published averages. Certain non-cash donations of property, especially automobiles and boats have additional requirements to submit documentation with the tax return. Non-compliance with these requirements will increase the likelihood of an audit.
- Hobby Losses – A trade or business is an activity entered into with a profit motive, if the profit motive or probability of achievement is absent or extremely low, the IRS can challenge the activity under the hobby loss rules. Under the Tax Cuts and Jobs Act of 2017, a reclassification of hobby expenses will result in complete disallowance. Having an activity that reflects operating losses over consecutive tax periods is likely to draw attention.
- Small Cash Based Business – Activities that transact a large portion of income in cash are on the IRS radar. If you have a cash business in your profile, don’t play games, make sure your activity is well documented. Poor records open the door for IRS to reconstruct income from their viewpoint, and you have the burden of substantiating your real income.
- Rental Properties – Real estate rental activities are subject to a number of complex rules. When a return profile has multiple properties and substantial losses, it can motivate IRS to take a look and see if you are complying with all the rules. If you are not making all the right elections and disclosures, IRS could potentially postpone the recognition of losses on rental property operations, increasing the current year income.
- Stock Trading, Capital Gains and Losses – Brokers are required to report exchange traded transactions to IRS on Form 1099B annually. The reporting forms can report basis and acquisition dates to IRS, or if a qualified non-covered security, omit basis information. When a profile involves significant transactions in non-covered securities, or transactions that are not reported on a 1099, the IRS may flag the return for review to check your documentation.
- Mortgage Interest – There are new rules limiting deductions for interest paid on a mortgage of a primary and second residence under the Tax Cuts and Jobs Act of 2017. First, the mortgage must have been originated for the purchase, construction, or improvement of the property. Interest on cash out refinancing transactions where the proceeds are not invested into the real estate is non-deductible. There is also a cap of $750,000 on the total mortgage debt eligible for the mortgage interest deduction. This is likely to be an area of future IRS compliance enforcement.
- Unusual Deductions – IRS does keep statistical analyses for income and deduction ratios for a variety of profiles and activities. Deductions that are unusually high, or strange for the activity can flag a return for an audit.
- Large Amounts of Cash – US. Treasury regulations require all financial institutions and most businesses to report deposits and withdrawals $10,000 and over to the Treasury Department. This includes a series of similar transactions exceeding the threshold. Another red flag arises when credit card reward points redeemed involve a significant dollar value that can provoke Treasury to have IRS look into the activity.