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10 red flags that invite tax audits
Statistically, most of us won’t have to worry about being audited by the Internal Revenue Service.
IRS Commissioner John Koskinen noted during a recent speech in Washington, D.C., that last year the tax agency conducted the fewest audits in a decade. Agency data show that in 2015, the IRS examined only 0.84% of nearly 147 million individual returns, down slightly from 2014.
The commissioner says he expects the trend of fewer audits to continue this year.
Still, if you’re part of the small group of taxpayers who have to answer tax collectors’ questions, it is no fun. To avoid that possibility, don’t wave any of these 10 audit red flags.
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Before you start feeling too confident about that less-than-1% IRS audit rate, consider your income level.
Over the past 10 years, the IRS has consistently audited more tax returns filed by wealthier taxpayers.
In 2015, the audit rate for folks with reported income of less than $200,000 was 0.76%. But if you made more than $200,000 last year, the IRS return examination rate more than tripled to 2.61%.
And if you were a millionaire, watch out. In 2015 the IRS reports that it audited 9.55% of returns showing $1 million or more in income.
The reason is simple: The IRS wants to focus on returns where errors could net the agency the biggest bang for its auditing efforts.
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Income other than basic wages
Most taxpayers report income that shows up on a Form W-2 from an employer, which sends the same annual wage information to the IRS.
If, however, you get most or even some of your earnings each year from self-employment income or contract payment, the IRS must depend on you to report the full amount.
Payers generally aren’t required to issue 1099 forms unless your earnings are $600 or more. Absent this third-party documentation, the IRS has no way, other than your honesty, to know if what you put on your return is accurate.
That’s why the agency tends to give added attention to returns that include income that’s harder to document.
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Forget to include some income and you’ll hear from the IRS, especially if it comes from a source that also reports to the tax agency.
This could be as simple as overlooking a 1099-DIV from an investment. As with employers and W-2s, investment firms and brokers also copy the IRS on their clients’ earnings. The IRS then uses automated computer programs to match this payer information to your individual tax return. A mismatch means audit, at least in the less-invasive correspondence form.
Don’t forget about other income sources, such as prizes or relatively small gambling winnings that might not trigger the need for tax documentation. All, regardless of the amount, are taxable income.
How could the IRS find out if you don’t tell on your 1040? If you brag about the added taxable income on social media or your windfall was featured in your local newspaper, the IRS might discover you’re telling everyone but it about your money. Do you really want to take the chance of answering IRS audit questions just to save a few tax dollars?
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People have always operated businesses from their homes. And the IRS has always paid close attention to such companies.
A home-office deduction is not an automatic tax-audit trigger. In fact, in recognition of how many people do their jobs from home, the IRS now offers a simplified way to claim this tax break. But make sure you follow the rules.
The main requirement is that the office space be used exclusively for work. Your office doesn’t have to be a separate room, but it must clearly be a work area. You can’t share the space with any part of your personal life.
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Noncash charitable deductions
Donating household goods and used clothing can benefit both your tax bill and your favorite charity. But be careful about your giving.
You must determine the value of the goods you give. The guideline is fair market value, or what a willing buyer would pay a willing seller for the item, not the amount you paid when you bought it years ago. If you inflate the values to boost the charitable-giving section of your Schedule A, the amount could raise IRS eyebrows.
Keep a list of the goods with the value you assigned. Having photos also can help if an auditor ever questions your deduction. And always get a receipt.
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Fat meal and entertainment deductions
Doing business means entertaining clients and potential customers. The IRS understands that. But excessive meal and entertainment claims could prompt the tax agency to give your tax return another look.
As with all things tax, keep good records. Show who was your guest and the business reason for meeting over a meal or after a show.
Generally you can claim only 50% of your business-related meal and entertainment expenses. A large deduction amount could indicate that you ignored the limit or inflated the amount spent in retaining or attracting new clients.
Also note that the IRS frowns on excessive business-expense claims. It specifically says that you cannot deduct entertainment expenses that are lavish or extravagant. This is a case-by-case determination, but common sense should tell you when you’ve gone past tax-deductible boundaries.
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Excessive business auto usage
Inflated claims for tax-deductible vehicle expenses also are of special interest to the IRS.
The brightest of auto audit red flags is claiming that you use your car 100% for business. That’s possible, but usually not the norm for drivers who use their personal auto for some business, too.
If you do legitimately use your vehicle 100% of the time for business, have complete records — logs with dates, times, distance, purpose of every trip — to show the IRS auditor who will be asking about your claim.
Also don’t mix your mileage write-off. When deducting business use of a car, you choose between claiming the IRS standard mileage rate or your actual auto expenses. You can’t combine them.
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Unusually high deduction amounts
Most people claim the standard deduction. However, if itemizing your expenses gives you a larger deduction amount, you should claim those costs. But don’t pad your allowable expenses.
The IRS selects returns for audit based partly on itemized deductions that seem excessive. A return is first screened by a computer program that scores it based on the agency’s Discriminant Information Function, or DIF. This analysis compares deductions, credits and exemptions on returns against norms for taxpayers in similar income brackets.
Deviate from those amounts and an IRS auditor may give your return a personal look.
This doesn’t mean you should forgo claiming all your deductions for, say, medical costs if you had major medical expenses during the tax year. It does mean be prepared to show documentation for all those allowable claims.
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Millions of people turn to hobbies to relieve stress and provide enjoyment in their lives. Some even make some money off their avocations.
Hobby earnings are taxable income. You can reduce that amount, however, by claiming your hobby-related costs as part of miscellaneous expenses itemized on Schedule A. For these costs to count on your taxes, they must exceed 2% of your adjusted gross income.
Some folks are tempted to pad expenses to clear the percentage hurdle. Don’t.
You can deduct hobby expenses only up to the amount of money you make on your hobby. If you have more, you might want to consider converting the hobby to a business, which would allow you to claim expenses that could produce a business-income loss.
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Earned Income Tax Credit claims
The Earned Income Tax Credit, or EITC, is a tax break available to lower-income workers. It also is one of the few refundable tax credits, meaning if you don’t owe taxes when you file, you could receive money if you’re eligible for the EITC.
The credit, however, is one of the more complicated tax breaks. Because it is confusing and because some individuals (or their unscrupulous tax preparers) intentionally fudge EITC claims, the credit is a regular on the IRS extra examination list.
To help eliminate EITC errors and cheating, the IRS provides an EITC checklist for filers and tax professionals. It also operates an EITC compliance program to ensure that tax preparers are diligent in filing only legitimate EITC claims.