Red Flags That Can Trigger an IRS Audit

by dave


The possibility of an IRS audit worries many taxpayers. But if you know what the targets are, you have a better chance of avoiding an IRS examination.

Of course, there’s no way to guarantee that your tax return won’t be examined since the IRS randomly chooses some returns to audit. So you should always keep meticulous records to prove your deductions. With that in mind, here are 12 audit red flags:

1. Not reporting all income from third-party payers. The IRS is adept at “matching” the income reported about you by employers, banks, and brokerage firms against what you put down on your tax return.

2. Missing deadlines. The IRS notices — and penalizes — taxpayers who mail their returns even a few days late. Auditors may wonder what other rules were disregarded.

3. Being self-employed If you work for yourself and file Schedule C, you have a greater chance of an audit. The IRS is especially suspicious of businesses that look like hobbies. (If you want to turn a hobby into a business and protect yourself from IRS scrutiny, read our previous article by clicking here.)

4. Collecting valuable fringe benefits. Auditors zero in on non-cash fringe benefits given to highly paid employees. These tax-favored perks include deferred compensation, stock options, split-dollar insurance and golden parachutes.

5. Claiming losses from part-time activities the IRS considers a hobby, such as horse breeding or photography. However, taxpayers have successfully fought the IRS on this issue by keeping accurate records, following industry practices and showing a profit in three of five consecutive years (two of seven for some horse businesses).

6. Not reporting stock trades. Keep scrupulous records of your investments. The IRS is aware that some taxpayers make numerous trades online and don’t keep track of the transactions as the law requires. (Under a tax law passed in 2008, more investment sale information is being provided to the IRS by brokerage firms.)

7. Dealing in cash. IRS auditors are trained to search every nook and cranny of the cash-based financial world to detect cheating.

8. Setting up an illegal trust. Uncle Sam has a hit list of fraudulent deals, including “family residence trusts” and some foreign trusts. Don’t believe claims that you can establish a trust that allows you to avoid taxes, yet still own and control the assets.

9. Donating a car to charity and taking a deduction that’s too big. Under current tax law, charitable donations of vehicles have strict rules for deductions in excess of $500. Beginning January 1, 2005, a donor’s allowable write-off depends on how the donated asset is used by the charity.

If the organization sells the asset without using it significantly for charitable purposes or making material improvements, the donor’s deduction is generally limited to the amount of gross sales proceeds received by the charity. The fair market value of the donation, allowed years ago, is no longer relevant.

10. Stepping out of bounds. IRS computers compare your return with those filed by other taxpayers with similar incomes. If your deductions are significantly higher, you may be asked why. Of course, this doesn’t mean you shouldn’t claim every deduction you are entitled to. You just need to be aware of how the audit process works and hang onto the proper records.

11. Deducting prohibited or suspicious items. You just can’t write off certain expenses, such as funeral costs and country club dues. There are other deductions the IRS is often skeptical about, such as expensive meals and home office write-offs.

12. Being a “tax protestor.” Some people refuse to pay because they claim taxes are unconstitutional. The IRS has little patience for these arguments.

Important point: Even if your return is audited, an IRS examination is nothing to lose sleep over. In many cases, the IRS asks for proof of certain items on a tax return and “closes” the audit after the documentation is presented.

Keep in mind that the 12 items listed above are only some of the IRS red flags. The tax agency changes its targets regularly.

Still fear a meeting with the IRS? Keep in mind that you probably don’t have to attend an audit. You can stay home and designate your tax adviser to act on your behalf.

About Scale Finance

Scale Finance LLC (www.scalefinance.com) provides professional CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance LLC has offices in Charlotte, NC, the Triangle, the Triad, Southern Pines, and Wilmington with a team of more than 30 professionals serving more than 100 companies throughout the region.

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