The IRS has been stepping up its efforts to ensure that Americans are accurately reporting the taxes they owe and is auditing a growing number of taxpayers, especially those with high incomes and complex financial arrangements. While all taxpayers are at risk of being audited, you may be more likely to attract the attention of the IRS if certain “red flags” appear on your return.
According to the IRS’s 2013 enforcement results, the chances of being audited have risen noticeably for wealthy taxpayers over the last several years. The percentage of individuals with incomes below $200,000 who were audited has decreased only slightly over the last seven years, from 0.93% in 2006 to 0.88% in 2013. For taxpayers with incomes over $200,000, the percentage rose from 2.57% in 2006 to 3.26% in 2013. Further, among individuals reporting incomes of more than $1 million, the percentage selected for audits jumped from 5.25% in 2006 to 10.85% in 2013.
But, even if your income level increases your chances of receiving an audit notification from the IRS, steering clear of certain “triggers” can help minimize the chances of being selected. In developing a strategy, it is helpful to know how the IRS singles out returns for audits.
Many audit targets are selected through the Discriminate Function (DIF) system. This screening system uses statistical formulas to analyze and score tax returns, identifying the returns that are most likely have a gap between the taxes owed and the tax liability reported. The system is intended to spot inconsistencies, such as when a taxpayer with a low income claims a large mortgage interest or charitable contribution deduction.
A taxpayer may also be audited if an obvious mismatch exists between the information reported and the amounts that appear on the 1099 and W-2 forms or other income statements. In other cases, individual taxpayers may be singled out for an audit because they are officers or shareholders at a company that is being audited. In addition, wealthy individuals with sophisticated business and financial arrangements, especially those with investments or bank accounts abroad, are being scrutinized more frequently as part of the IRS’s Global High Wealth Industry program.
While you do not want to forgo taking advantage of tax breaks to which you are entitled in order to avoid being audited, it’s important to be aware that claiming certain deductions or credits are especially likely to trigger an audit. In addition to large mortgage interest or charitable contribution deductions, these red flags include claiming a home buyer credit, a home office deduction, a deduction for 100% business use of a vehicle, or a large deduction for unreimbursed employee business expenses, such as travel, meals, and entertainment. The IRS may also scrutinize individuals who have unusual fluctuations in income, earn a substantial amount of their income in cash, claim large Schedule C business losses while earning wages, or have offshore accounts or other foreign income.
Before filing a return, make sure that you have all of the receipts, forms, and other documentation necessary to back up all of the information provided and deductions claimed. Also, be sure to contact one of our qualified tax professionals for advice on how to minimize or manage the types of claims that could put you on the radar of the IRS.