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Don't wave any of these tax audit red flags

Tax audit_1040 and audit stamp

The Internal Revenue Service is under scrutiny again, this time for conducting unusual and intensive audits of two top FBI officials who were critical of Donald J. Trump.

The IRS has asked the Treasury Inspector General for Tax Administration (TIGTA) to investigate how former FBI director James B. Comey and his deputy, Andrew G. McCabe, both were subjected to a rare, compliance research audit that is supposed to random.

Congress also will get involved. Rep. Bill Pascrell (D-New Jersey) already, and repeatedly, has taken IRS Commissioner Charles Rettig to task for IRS shortfalls and missteps. In May, during a hearing before the House Ways and Means oversight subcommittee that he chairs, chided the IRS and its top executive for the disparity of taxpayer treatment.

"Whether the IRS is processing returns, answering taxpayer questions, or conducting audits, there cannot be one tax system for the wealthy and another for everyone else. And yet, that is exactly what we have," Pascrell said then.

While the Comey and McCabe audits shifted, albeit in questionable fashion, the IRS examination needle a bit more in the direction of more IRS attention on higher earners, it exposed another audit issue. This time Pascrell took to social media to call for the firing of Rettig.

Audit rates falling, but still a concern: Meanwhile, as this tax and political battle wages, it also raises the question of just what might get the IRS to take longer looks at all us regular taxpayers' returns.

The good news, from a potential audit standpoint, is that IRS examinations of filings have been falling.

The Government Accountability Office (GAO) report that prompted the May Ways and Means subcommittee hearing, Trends of IRS Audit Rates and Results for Individual Taxpayers by Income (Report No. GAO-22-104960), found that between 2010 and 2019, audits of individual income tax returns declined across the board. To Pascrell's point, however, the GAO found the drop in audits was most pronounced for taxpayers with incomes of $200,000 or more.

UPDATE, Sunday, Aug. 7, 2022: The Senate approved the Inflation Reduction Act of 2022 today along a 50-51 party-line vote, with Vice President Kamala Harris casting the deciding vote. The House is expected to consider the measure on Friday, Aug. 12. The bill includes $79 million for the IRS, with most of that going toward increased examinations of wealthier taxpayers.

So that, regardless of our earnings level, we don't end up facing off with an IRS examiner, here are eight red flags that could invite an audit.

1. You have income other than basic wages. Most taxpayers report income that shows up on Form W-2. This annual wage income also is reported 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 in part on your honesty in reporting 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.

2. You didn't report all your income. 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 man.

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 prize or relatively small gambling winnings that might not trigger the need for tax documentation. All, regardless of 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?

3. You didn't tell the IRS about cryptocurrency transactions. Virtual currency has been all the rage, then all the bane when values dropped, for many investors. It's also a potential tax audit signal.

Part of the reason is that the IRS believes unreported (and untaxed) crypto transactions are a major contributor to the trillion-dollar Tax Gap. To get their hands on at least some of that digital money's tax liability, the IRS asks about crypto right at the top of Form 1040.

Specifically, it wants to know if you received, sold, traded, or disposed of any financial interest in a virtual currency. Don't answer this checkbox question and the IRS will ask it again, perhaps along with a few queries. Also, don't forget about those nonfungible tokens (NFTs).

Despite cryptocurrency's ostensible origin to make money making more egalitarian, it has complicated tax filings. Most investors use a variety of exchanges and digital wallets, the transactions of which must be tracked so they can be reported, if required, to the IRS.

If crypto is part of your investment portfolio, hire a tax professional who is experienced in the financial and tax components. It could save you a meeting with an IRS examiner.

4. You have a home-based business. 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 in both cases, make sure you follow the home office deduction 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 be a clearly defined area. You can't share the space with any part of your personal life.

But the work from home trend that exploded during the COVID-19 pandemic has posed new tax challenges for filers. You're not entitled to claim your home office just because your boss instituted tough coronavirus protocols. Claiming this tax break as an employee, instead of an independent contractor or small business owner, is a sure way to get the IRS asking questions.

5. You reported business losses. Many home-based or other small businesses struggled during the pandemic, so it's not surprising that they had lower than usual income amounts to report. But if your entrepreneurial operation continually runs in the red, the IRS will likely look into it. When you start a business, the IRS expects you to do so with the goal of turning a profit. The tax agency doesn't look kindly on folks who set up a sham business as a way to write off a lot of expenses that really are personal, non-deductible costs.

It generally operates on the assumption that if your so-called business doesn't make money in three of the past five years, it's actually a hobby.

If you are legitimately losing money, then report that. But be ready to prove that you were trying to be successful financially. Keep complete, thorough records — including allowable work-related miles, which have two different rates this year — to prove your business intent and unfortunate losses to the IRS.

6. You withdrew money from retirement accounts. The COVID-19 pandemic put lots of folks into financial turmoil. Many who lost income, either from reduced hours or being laid off, turned to their retirement savings to make ends meet. That's still happening as the pandemic lingers.

While it may have kept your rent paid, lights on, and refrigerator filled, the traditional IRA or 401(k) distributions could be tax trouble.

When you take money out of these tax-deferred accounts, you owe tax on the amount. When you take the cash out before you turn 59½ you also face a 10 percent early distribution penalty. This penalty was waived by a temporary tax change during the height of the pandemic, but kicked back in last year.

The IRS knows about the withdrawals because the account manager sends it the same transaction information, Form 1099-R, that it sends you.

What if you tapped a Roth IRA or 401(k) early? Some of those early distributions also could be taxable. The IRS' online tool can help you figure out when this might be the case.

7. You claimed unusually high deduction amounts. Most people have always used the standard deduction amount. That number went even higher after 2017's tax reform bill made some major changes to Schedule A itemized deductions. Still, if itemizing your expenses gives you a larger deduction amount, you should claim those costs. Just don't pad your allowable expenses.

The IRS in part selects returns for audit based 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 will give your return a personal look.

Again, the DIF factor 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, though, that you must be prepared to show documentation of all those allowable claims.

8. You made easily avoidable errors on your tax return. To err is human. It also could get you audited. In fact, lots of us have technically faced an IRS exam. It's just been in the form of a correspondence audit. This is where the IRS catches an error on your 1040 and mails you a notice of your mistake, along with the changes the tax agency made and a bill for the additional tax you owe.

These typically are math errors. And note that a wrong numerical entry or transposed numbers on one line can create exponentially big tax problems if that info is transferred to another line or form.

The number error also applies to Social Security numbers. Enter wrong tax identifying digits for yourself, your spouse, or any dependents, and you could lose tax breaks based on your filing status or tax credits you claimed.

Math errors are among my earlier post on 12 common filing mistakes to avoid. Don't make any of them unless you want to talk to the IRS after you file your return.

These eight items are just a few that could get you into audit trouble. You can find more in my previous audit warning post Don't wave any of these 13 tax audit red flags. Yeah, I have a matador mindset when it comes to tax examinations.

The best thing you can do, though, to stay off IRS radar is to file a correct, complete tax return on time. The IRS will thank you.

It also will leave you alone until the next Tax Day.

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