One of the many reasons that people hate taxes is that after the hassle of filing, then comes the fear that a Form 1040 mistake will mean an audit.
The sort-of good news for taxpayers is that the Internal Revenue Service hasn't been auditing as many people in recent years. The agency has had other things to worry about, like doing its myriad jobs with fewer staff and less money. Then there's COVID-19, with added pandemic payments that the IRS is tasked with distributing.
Things could be changing, though.
More people are getting vaccinated, meaning the end of the coronavirus crisis and its widespread effects could be in sight. Plus, the Biden Administration wants Congress to provide the IRS with more money to audit tax cheats.
Regardless of what happens on Capitol Hill, you still need to be sure to file your returns as accurately as possible. That means claiming all the tax breaks for which you legitimately qualify.
Even then, though, some 1040 entries are audit red flags. Here are 13 things that could tempt the IRS to take another look at your tax return.
Claim them if you're eligible. Just do so carefully and follow the IRS rules. And be ready to answer any follow-up filing questions if they attract an IRS examiner's attention.
1. You earned a lot of money.
The budgetary concerns that Biden hopes to ease have forced the IRS to refine its audit strategy. To get the biggest bang for its for now limited tax examination bucks, the agency has focused on higher income earners. As noted, if the IRS gets the money President Joe Biden is recommending, it will look at even more millionaire filings.
Most of us have little or no control over how much we make. And most of us would like to make more. Just be aware that when that does happen, the IRS is going to take a little extra time examining your return.
2. You claimed the Earned Income Tax Credit.
There are some taxpayers who definitely aren't high earners, but who each year find themselves the target of added IRS scrutiny. They are the folks who claim the Earned Income Tax Credit, or EITC. This tax break was created to help lower- and middle-income workers. The credit pays more to families with children, but single, child-free filers also can benefit from the EITC.
Not only does it provide a dollar-for-dollar offset of any tax owed, it's also a refundable credit, meaning if after erasing your tax liability, any leftover EITC comes back to you as a refund.
The EITC, however, is one of the more complicated tax breaks. It got even more difficult recently when the American Rescue Plan Act, aka the last COVID relief law, expanded the EITC. The intricacies of the EITC create not only honest confusion and mistakes in claiming it, but also makes it easier for unscrupulous filers to cheat when claiming the EITC. That's why the IRS already is required to hold returns where the EITC is claimed for added attention. That same extra IRS look delay also applies to filings that claim the additional child tax credit.
3. Your dependents aren't tax dependable.
All those folks who rely on you can pay off at tax time, like with the just discussed EITC. The key is to make sure your dependents meet IRS requirements. Wrongly claiming a child or listing other questionable dependents on your 1040 will automatically attract unwanted IRS attention.
Dependent issues often arise when parents don't file taxes together. Only one can claim a youngster as a dependent and make use of associated tax breaks, such as the Child Tax Credit or Child and Dependent Care Tax Credit. Dependency issues also get confusing when an adult relative, such as a grandparent, lives with or helps support the child.
While mistakes here often are honest, they still will make the IRS take another look and ask additional questions.
4. You are self-employed.
One way to have a bit more control over earnings is to become your own boss. The IRS joins those applauding your enterprising spirit. But the tax agency also knows that self-employed taxpayers have a lot more ways cheat on their taxes. This is largely because many business transactions aren't documented in a way that helps the IRS. Unlike when you work for a company where your salary is set and taxes are withheld and sent to the IRS throughout the year, self-employment gives filers, shall we say, wiggle room in reporting income and the taxes due on it.
The IRS essentially has to trust a self-employed filer to honestly report income and expenses. But it also knows from decades of filing experience that self-employed people sometimes claim excessive deductions — really, you used your only auto 100 percent of the time for business purposes? — and don't report all their income. So the IRS tends to take a greater interest in the returns of self-employed workers.
The IRS also is on the lookout for business owners who aren't very good at their jobs. If your self-employment efforts don't eventually produce a profit, the IRS might think you're simply doing whatever you're doing to produce losses that lower or even eliminate your tax liability. In fact, the IRS typically expects a business to turn a profit in at least three of five consecutive years.
5. You are part of the gig economy.
The self-employment tax reporting has been complicated by the explosive growth in gig workers. Then COVID-19 arrived. Facing pandemic produced job losses, millions cobbled together gig work to pay their bills. Others added side hustles to cover income lost when their regular job hours were cut.
While the cash helped, it also created tax troubles. Many gig workers, especially first-timers, are unaccustomed to dealing with 1099 income. This is the money paid for ad hoc, nonemployee efforts. When a job pays at least $600, the payer will send the worker a Form 1099-NEC, which is copied to the IRS. When a contractor forgets to include this money on his or her tax return, that filer is guaranteed to get an IRS notice about the unreported income.
Other times, the amounts are less than the 1099 trigger amount or are in cash. It's easy to lose track of these amounts. But even if you don't get a form detailing the amounts, it's taxable income. And the IRS has ways of tracking, especially if you file a return with other documented income. So be sure to report all your employment (and other) income.
6. You claimed the home office deduction.
This has been a long-standing, and misunderstood, potential audit item. People used to forgo this legitimate claim out of fear the IRS would audit them. That wasn't necessarily true, especially as self-employment has become more common. Now, however, the IRS will be taking a closer look at home office deductions. The reason is, you guessed it, the coronavirus.
For most self-employed folks, even if the self-employment is a side job, the home office claim is still a valid and valuable one. But in 2020, millions of employees found themselves working from home (WFH) when COVID-19 pandemic protocols prompted the closure of their offices. In these cases, these employees generally are not allowed to claim the home office deduction. If you are an employee and not self-employed, the home office tax break doesn't apply.
Many WFH individuals also could face audit issues from state tax offices, as their changed work location means potential new tax liabilities in different jurisdiction.
7. You have rental real estate.
Rental properties not only offer property owners some added cash, but also advantageous tax treatment. Under the 2017 tax reform law, aka the Tax Cuts and Jobs Act (TCJA), rental owners generally will enjoy lower ordinary income tax rates that apply to more inclusive income brackets. Then there's the tax benefit of long-term capital gains tax rates when you get around to selling your property.
However, if your rental property generates a tax loss, and most do at least early in their rental lives, things get complicated. And complicated is where IRS examinations thrive. If you have rental property, you also should have a tax professional who can help you maneuver the intricacies and answer any questions the IRS might have about your real estate tax claims.
8. You make virtual currency transactions.
Cryptocurrency activity is another area where professional tax help is a good idea. The IRS has put special emphasis on virtual currency this year, moving its question about transactions to the top of Form 1040. Basically, the IRS is trying to remind cryptocurrency investors that they must report any gains or losses in connection with bitcoin and its brethren. If you answer "yes" to the virtual currency checkbox question, the IRS will look for details on those transactions in your filing.
9. You have money in overseas accounts.
If you own an account in a foreign country, make sure you report it if you are required to do so. The penalties for willful violation of overseas holdings reporting rules can be steep.
For U.S. citizens living on U.S. soil, the Foreign Account Tax Compliance Act, or FATCA, demands that if the value of your overseas account's assets was more than $50,000 ($100,000 for married couples filing jointly) on the last day of the tax year, or more than $75,000 ($150,000 for married couples) at any time during the year, you must report it on Form 8938 as part of your tax return. (The thresholds are higher for U.S. citizens living abroad.)
This is separate from the so-called FBAR (Foreign Bank and Financial Accounts) reporting, which is not filed as part of your tax return. FBAR's Form 114 is submitted separately to the Treasury Department's Financial Crimes Enforcement Network, usually referred to as FinCEN. The FBAR filing is required of Americans with more than $10,000 held overseas.
Keep in mind that the IRS might find out about overseas accounts even if you don't disclose them via FATCA or FBAR filings. Foreign institutions are also required to disclose account holdings by U.S. citizens.
10. You claim large itemized deductions.
The TCJA dramatically increased the standard deduction amounts. As expected, fewer taxpayers are itemizing their tax-deductible expenses on Schedule A. But fewer isn't all. Some still find their collected receipts provide a larger amount to deduct. That's fine. Even the IRS tells you to use the deduction method that gives you the best tax result.
But the IRS (and I) also say deduct legally. Don't go padding the itemized expenses that are still allowed, such as charitable donations, some state and local taxes, and many medical cost. Unusually large write-offs, which are those that seem to be excessive in relation to your income, will attract IRS scrutiny thanks to its computer scoring system, aka DIF, the acronym for discriminant information function.
11. You got tax help paying for your health care.
Obamacare, or as it's officially named the Affordable Care Act (ACA), is still in still in effect. In fact, the Biden Administration already has expanded some parts of it in the latest COVID relief law. Although folks have been dealing with the ACA for years, it still can be confusing. It also could pose a possible audit issue.
One area where you need to pay particular attention is the premium tax credit (PTC). This federal subsidy helps eligible taxpayers cover the cost of medical coverage obtained through a health care marketplace. Most who get the PTC get it in advance so they don't have to pay as much in out-of-pocket medical insurance premium costs. But you must reconcile this advance PTC amount when your file your tax return. The Form 1095-A you'll get will help with this filing task. If you ignore it or miscalculate, you could end up having to repay an advance PTC amount, as well as a possible ACA-related penalty.
12. You have a crooked tax preparer.
Unfortunately, every filing season shady tax preparers set up shop, hoping to lure taxpayers looking for help. There are many crooked tax pro variations.
Some unscrupulous preparers set up pop-up offices that appear for a few days or weeks then disappear. Others base their fees on a percentage of your refund, meaning they'll exaggerate tax entries to get a bigger and not necessarily legal amount back from the IRS. Other dodgy tax pros ask their victims to sign blank forms, then fill in items that the taxpayer never sees. And you never see these so-called ghost preparers again, as they disappear like phantoms in the night with your illegally calculated tax refund.
Regardless of which crooked preparer you fall prey to, by the time the IRS discovers the dubious discrepancies they created to steal your and IRS money, you are the one left to deal with the aftermath. You, the duped taxpayer, are on the hook for paying back the wrong amount and any penalties.
13. You filed the old-fashioned paper way.
Yes, this still happens. Although most of us or our tax preparers now e-file, there still is a die-hard group of old-fashioned pen-and-paper tax filers. Hey, to each his or her own. But by using software to complete your returns, many common mathematical errors are eliminated (as long as you enter the correct info to start with), along with fewer transposed digits or missing of required entries. But filing by hand means your data has to be entered by IRS employees, providing another chance for human error in connection with those entries. Plus, there's the added chance that the IRS worker may notice one of your mistakes.
Are you scared now? Don't be. I know most of the ol' blogs readers are honest taxpayers. And ever if you do make an innocent error, that won't spark a full-blown audit.
You'll likely get a letter or notice, known as a correspondence audit, explaining the situation and what you need to do to make things right. That won't be problem as long as you have good records for everything you enter on your tax return.
Even if the review progresses, you still should be OK as long as you hire a reputable tax pro who's experienced in the audit process.
Most of all, though, don't invite any extra IRS attention by waving any of these baker's dozen audit red flags.