Red Flags and IRS Audits

The There is a tax gap in the United States.  Every few years the IRS does an analysis of overall compliance with federal tax laws and uses that information to estimate the annual shortfall of revenues. That shortfall is known as the tax gap, and the most recent estimate put that amount at well over $450 billion. (Yes, "B"illion.) Through enforcement efforts (like audits) the IRS typically recovers about $50 billion per year, but with a gaping difference between the shortfall and collections you can understand why they are eager to enforce where they can.

The first Form 1040 was filed for the year 1913, and since then billions of tax returns have been filed. The IRS uses its wealth of historical data to perform statistical analyses, determining what is or is not "normal," to help them identify when something looks out of line. These red flags are sometimes unavoidable, as even legitimate deductions can cause statistical anomalies, increasing the likelihood of being selected for enforcement action.

Here is a list of what many consider to be red flags for the IRS. None of these guarantee an audit, and none of them are automatically cause for concern. These are all legitimate and legal, but having them may place you outside the boundaries of a "normal" return. That means you might hear from the IRS. It does not mean you shouldn't report it, or that you will lose and owe additional tax.

1. Making a lot of money
2. Not reporting all taxable income
3. Having higher-than-average deductions
4. Having higher-than-average charitable deductions
5. Reporting a business on Schedule C
6. Having a business with a known likelihood of mostly cash receipts
7. Claiming to be a day-trader and not an investor
8. Multiple years of losses on Schedule C
9. Reporting losses for a business that the IRS might call a hobby
10. Having rental losses
11. Deducting meals, travel, and entertainment for business purposes
12. Claiming a home-office deduction
13. Business vehicle deductions (especially at 100% business use)
14. Gambling losses
15. Having unreimbursed business expenses

We will discuss each of these items in greater detail in future posts. For now, remember that these are all legal, and simply having them does not automatically mean you will be audited. But if you ever do get a love letter from the IRS, give us a call and we will help you respond.