Common Tax Return Red Flags to Avoid

5/31/2018 - By David Tate, CPA

It usually starts out like this:

Dear Taxpayer:

Your federal return for the periods shown above has been selected for examination.

Have you ever received one of these letters? If so it can be a very stressful event! Your first thought is “Why am I being audited?”

Sometimes it is pure luck that your return has been selected for audit by the IRS, but most of the time it is due to “red flags” that the IRS has identified. “Red flags” is a term used for items of income or deductions in a return that may stick out as unusual or may be an irregularity for that year. Or, maybe there is something in the return for which the IRS is keeping watch. These items usually have been taken advantage of or abused in past years by taxpayers and when audited do not hold up under the rules of the Internal Revenue Code for taking that deduction. 

Common Red Flags

Below are examples of “red flags” that could trigger an IRS audit:

Claiming a home office deduction

This is probably one of the most abused deductions by taxpayers and consequently can get your tax return selected for an IRS audit. Whether its exaggerating the amount of space you claim for a home office or the office is not used 100% for business, this deduction raises that IRS red flag quite often. The IRS states that you must use that part of the home that you are claiming as a business office to be used “exclusively and regularly for your trade or business.” That means the space must be used for work and work only. Your couch in front of the TV probably won’t pass inspection.

Failing to report income you received

An easy way to trigger an audit is to not report all your income. Failing to include a 1099 or a K-1 that was issued to you will cause the IRS to tag your return for a red flag. The IRS receives this information from the taxpayer who paid on the income and was required to report this information to the IRS. This information is then loaded into their computer data base. When you file your return, the income is compared to the information in their data base and if it doesn’t match up, you will most likely be getting a letter for either a request for additional information or a letter that you have been selected for audit.

Filing a schedule C with large losses or large expense items

Large or unusual expense items can be considered a red flag. For example, a taxpayer who traveled a lot for his business was recently audited by the IRS. When he filed his tax return, he included on his Schedule C for reporting business income and expenses an amount of travel expenses that greatly exceeded any other expense he had for the business. During the IRS examination, the IRS agent informed the taxpayer that his return was chosen for audit solely for that reason. While he was able to substantiate most of the travel expenses as business, he was disallowed some travel expenses that were declared either personal or that he did not have the support to substantiate that the travel expenses were reasonable and necessary to carry on his business.

When it comes to large losses being filed, it is not unexpected that a start-up business will have losses in the first couple of years. However, consistent losses over several years, is considered a red flag and will get the IRS’s attention. Businesses, unlike hobbies, are required to have a profit motive. It is a good idea for a taxpayer to have a written business plan outlining how their business will obtain profitability. 

Claiming bogus or large charitable deductions

If you don’t have valid support for your charitable deductions, don’t claim them. The IRS says that if claiming a charitable deduction of $250 or more, the taxpayer is required to obtain and keep a contemporaneous written acknowledgment for a charitable contribution. Without this written acknowledgement, the charitable deduction will be disallowed. The IRS website provides more information on what should be included on the written acknowledgment to support the charitable deduction. 

KEEP IN MIND: Claiming a disproportionate large charitable deduction on your return could raise a red flag. A claim of $10,000 in charitable deductions on your tax return with your $50,000 salary may raise some eyebrows.

Preparing your return with rounded numbers

Nothing says I made up the numbers in my return like using nice even, rounded numbers. When preparing your return, use actual source documentation as support for your income and deductions. The chances that your business income or expenses end up being rounded to $100 or $1,000 intervals is extremely rare. Be exact and round up or down to the nearest dollar to prevent your tax return from being red flagged by the IRS. 

Getting audited by the IRS can be quite stressful and navigating through some of these “red flag” audit items can be complex. Responding to an IRS audit also requires producing sufficient and organized support for the information being requested by the IRS examiner. If you receive a notice that your tax return has been selected for an IRS audit, take a deep breath and contact myself or a Saltmarsh tax professional.

About the Author | David Tate, CPA
David is a director in the Tax & Accounting Services Department of Saltmarsh, Cleaveland & Gund. David has 20 years of public accounting experience, providing tax services to consolidated groups, S-Corps and Partnerships for both public and private entities with considerable experience in the technology, retail, professional services, manufacturing, and the oil & gas industries.

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