Don't Mess With Taxes

Photo by Philipp Deus

Every taxpayer and tax circumstance is unique. However, there are some things that trigger trained Internal Revenue Service examiners.

As you’re finishing up your 2024 tax return, take another look to see if any of the 10 situations items show up on your Form 1040.

They don’t guarantee that your return will be pulled for further attention and possibly a full-blown audit.

But they could cause the IRS to conduct a correspondence audit, which is sending you a notice asking for clarification about a questionable item on your return.

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 payments in connection with a side gig, the IRS must depend in part on your honesty in reporting the full amount.

Payers of contract workers 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 includes the extra earnings mentioned in #1, as well as from something as simple as overlooking a 1099-DIV from an investment. Investment firms and brokers, like employers of fulltime staff, also copy the IRS on the earnings they pay. 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 continues to be intriguing for many. It's also a potential tax audit signal.

Part of the reason is that the IRS believes unreported (and therefore untaxed) crypto transactions are a major contributor to the Tax Gap, the billions in taxes Uncle Sam is owed, but the IRS hasn’t been able to collect. 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. If you don't answer this checkbox question, the IRS will ask you again, perhaps along some other inquiries about your return.

Despite cryptocurrency's ostensible origin to make money making more egalitarian, it has complicated tax filings for many investors. So, 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. The IRS also has long 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 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.

And note that if you’re an employee, you likely won’t qualify for the home office tax deduction. Simply doing your salaried work from home, either 40 hours a week or under a hybrid arrangement with your employer, doesn’t count even if you meet the home office requirements. 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 take a while to become profitable. 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 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. And if a business never makes money, the IRS likely will view it as a sham operation created 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, preferably separate from your personal finances, to prove your business intent and its unfortunate losses to the IRS.

6. You withdrew money from retirement accounts. For many, their largest savings account is their nest egg. So, when a crisis arises, either from unexpected illnesses or job loss or a major natural disaster, it’s the only place they have to turn for funds.

While the use of retirement money to pay a mortgage or rent, keep you utilities on, and refrigerator filled, using retirement funds from traditional IRA or 401(k) plans 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.

In certain cases, distributions are allowed from workplace plans to help individuals deal with cases hardship, defined as an immediate and heavy financial need. IRS.gov also has a chart listing early retirement account withdrawals that escape the 10 percent penalty. Some of the exceptions apply only to IRAs, some apply only to workplace retirement plans, and others apply to both.

7. You claimed a whole lot of itemized deductions. 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 gave an unusually large amount to a charity. If you do still itemize, gifts to nonprofits are a good way to up your overall deductions total on Schedule A. But if you do make a very large donation, especially if it is a lot compared to the income you report, expect the charitable gift claim to get some added IRS attention.

True, tax law does now allow you to give up to 60 percent of your adjusted gross income (AGI) to authorized charities and claim the amount as a tax deduction. That doesn’t mean, however, that the IRS will just let the gift go by without additional examination.

So, make sure you have met the tax-deductible donation rules. That includes having documentation of your gift from, again, a nonprofit that has met IRS muster. You don’t have to send the receipt of your donation in with your tax return. Just have it handy if the IRS asks.

9. You claimed a refundable tax credit. Tax credits are better than deductions because credits offer a dollar-for-dollar reduction of any tax you owe. And a handful of credits are refundable, meaning that if you don’t owe Uncle Sam any money, the credit could create a tax refund.

Fully refundable tax credits include the fully refundable Earned Income Tax Credit (EITC) and the Premium Tax Credit (PTC).

The EITC is for working taxpayers who make lower- or moderate incomes. The credit is more valuable for those with larger families, with a maximum of $7,830 available to qualifying filers of 2024 tax returns.

The Premium Tax Credit helps compensate taxpayers who buy healthcare coverage through the Health Insurance Marketplace and meet other criteria. This is a refundable credit based on your income and the cost of your healthcare plan.

Partially refundable tax credits include the Child Tax Credit (CTC), the refundable portion which must be claimed as the Additional Child Tax Credit (ACTC), and the American Opportunity Tax Credit.

Up to $1,700 of the $2,000 CTC is refundable for the 2024 tax year.

The American Opportunity Credit is worth up to $2,500 to cover qualifying higher education costs. Up to $1,000 of the education credit

Unfortunately, for both the IRS and taxpayers, claims of these credits often are wrong, either because the tax break is complicated and confusing (looking at you EITC) or because unscrupulous filers and/or tax preparers try to cheat using refundable credits.

The IRS already must by law hold until mid-February any refunds generated on returns that include the EITC or ACTC. That extra time is for the agency to take a closer look at these claims. And while there’s no specific delay on the other credits, you can be sure IRS examiners are looking at those more closely, too.

Again, if you qualify for a full or partial refundable tax credit, by all means claim it. But be ready to show the IRS why you are rightfully seeking this tax refund-producing tax break.

10. 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 the aforementioned 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, which leads the list of the 10 most common tax errors to avoid. Note, too, 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.

Odds of audit aren’t high: The good news is that even if you wave any of these red flags on your tax return, the odds of you being audited are low.

Even though the IRS got additional money under the Inflation Reduction Act to beef up its audit staff, that personnel was supposed to focus on higher earners who file more complex returns.

Yes, Congress is trying, and succeeding to a degree, to claw back those funds. And Department of Government Efficiency (DOGE) activity, including layoffs, is hampering the IRS this filing season.

All this means that most of us more average Joe and Jane Taxpayers won’t have to worry about fielding tax return questions from the IRS. But we also don’t want to do something that unnecessarily attracts attention.

So, file a correct and complete tax return on time. Also claim all tax breaks for which you qualify. But have your supporting material on hand, just in case.

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