Don't Mess With Taxes

Photo by Zachary Keimig on Unsplash

The Internal Revenue Service is processing millions of returns that are coming in as Tax Day for the main 2024 tax season nears. But thanks to added Inflation Reduction Act money, the tax agency also is looking more closely at some returns.

It recently resumed sending automated notices that had been on hold since February 2022 due to COVID-19 pandemic problems.

And it got even more attention when IRS Commissioner Danny Werfel announced that his agents were going to crack down on individuals who use corporate jets for personal travel jets.

While most of us aren't the target of the IRS' new compliance efforts aimed at wealthier taxpayers, it's still natural to worry a bit that the tax agency might find a reason to audit our returns, too.

The best way to stay off IRS audit radar is to file complete and correct 1040s.

The next best way to stay off IRS audit radar is to avoid, where possible, waiving these 10 audit red flags.

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 or gig jobs, 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 what you decide to tell it. 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. This isn't the same as forgetting about that $300 your neighbor paid you for photographing his child's first birthday party. (I know none of the ol' blog readers would intentionally not report this income.) We're talking here about neglecting to including income information that came via a tax statement issued by the payer.

When this happens, the official reporting is not just to you. The IRS also is copied, and 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, tax notice form .

So make sure you have all the tax statements you got earlier this year when you do file. And enter that information correctly. Transposed amounts also will produce a discrepancy that will get the IRS' attention.

3. You didn't tell the IRS about cryptocurrency transactions. The IRS is not kidding around when it comes to virtual currency. The agency believes unreported (and untaxed) crypto transactions are a major contributor to the billion-dollar Tax Gap.

To at least learn about this potential revenue, the IRS has for years has placed a crypto question prominently on the 1040 form versions used by most filers. Those are the basic Form 1040 individual income tax return; Form 1040-SR used by filers age 65 or older, and Form 1040-NR filed by U.S. nonresident alien taxpayers. For 2023 taxes, the crypto question has been added to four other forms. Ignore it at your own risk.

If you don't answer this checkbox question, whether yes or no, your return is considered incomplete. So the IRS is likely to ask it again, perhaps along with a few other crypto queries.

Plus, 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. So the claiming of 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 regardless of which home office deduction method you use, follow the rules. The main requirement is that the office space in your residence be used exclusively for work. It 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.

And if your work-from-home set-up with your company during the coronavirus pandemic has become a permanent hybrid arrangement, then you're probably not going to qualify for the home office tax claim. Trying to do so 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. Speaking of small businesses, it's not unusual for entrepreneurial endeavors to struggle, especially in their early years. But if your company 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 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. The IRS also knows that some folks set up sham businesses as a way to write off a lot of expenses that really are personal, non-deductible costs.

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 to prove your business intent and unfortunate losses to the IRS.

6. You withdrew money from retirement accounts. During the height of the COVID-19 pandemic, lots of people turned to their retirement savings when they lost their jobs. That pre-retirement withdrawal trend is continuing. Vanguard Group says that 2023 saw early withdrawals from retirement accounts hit a record 3.6 percent of the 5 million accounts the investment firm administers, up from 2.8 percent in 2022.

While you have to do what you must to make it through a tough time, taking money out of traditional IRA or 401(k) distributions also could create tax trouble. When you withdraw from these tax-deferred accounts, you owe tax on the amount. And when you take the cash out before you turn 59½ you also face a 10 percent early distribution penalty.

The IRS knows about the withdrawals because the account manager sends it the same transaction information, Form 1099-R, that it sends you. And IRS examiners will be looking to see if that amount is properly reported on your taxes.

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 essentially doubled the standard amounts. But if itemizing your expenses on Schedule A gives you a larger deduction amount, then by all means 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 claimed the Earned Income Tax Credit. This is a valuable tax break for lower- and middle-income taxpayers. The Earned Income Tax Credit, or EITC, also is a tax break that automatically gets added IRS scrutiny. In fact, the IRS is required to hold returns until Feb. 15 when the EITC is claimed.

That automated delay is to allow the IRS more time to review EITC claims, which are complicated. These intricacies create not only honest confusion and mistakes in claiming the EITC, but also make it easier for unscrupulous filers to cheat when claiming the credit.

9. 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.

Such math errors are among the 10 most-common filing mistakes  taxpayers make every filing season. If you make any of these errors, you'll probably end up explaining them to the IRS after you file your return.

10. You filed the old-fashioned paper way. Yes, this still happens. Although most of us or our tax preparers now e-file, there still are times when paper is the only way you can file a particular return. And there still is a die-hard group of old-fashioned pen-and-paper taxpayers who rely on the U.S. Postal Service to submit their returns.

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.

On the other hand, filing by hand means your data has to be entered by IRS employees. Not only does this entry step provide another chance for human error in connection with your return, there's the possibility that the IRS employee inputting your info might notice other issues with your return.

Tax care is the best move: Are you scared now? Don't be.

Some of these instances, such as non-W-2 earnings or a tough business year or using retirement money to cover an emergency, are unavoidable. Just make sure you know of any associated tax implications and appropriately account for them on your filing.

If, however, you do hear from the IRS about any of these 10 audit red flags or something else, don't panic. Just be prepared to fully explain, and document, your 1040 entries.

And if you do end up facing a full-blown IRS examination, hire a reputable tax pro who's experienced in the audit process.

You also might find these items of interest:

• Do you live in a tax audit hot spot?
• If IRS asks, you've got some 'splaining to do
• Tax audit odds are low, but if it happens be prepared

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