The IRS has been stepping up its efforts to ensure that Americans are accurately reporting the taxes they owe. This means that the IRS is auditing a growing number of taxpayers, especially those with high incomes and complex financial arrangements. While all taxpayers are technically at risk of being audited, you may be more likely to attract the attention of the IRS if certain “red flags” appear on your tax return.
How Many Taxpayers Are Audited?
According to the IRS’s enforcement results, the chances of being audited have risen noticeably for wealthy taxpayers over the last several years. While only about 1 percent of all people who filed a 1040 Tax Form faced an IRS audit last year, the percentage of taxpayers earning more than $1 million has risen to more than 12 percent. Among individuals reporting incomes of more than $200,000, the percentage selected for audits exceeded 30 percnet last year. The percentage of individuals with incomes below $200,000 who were audited has increased only slightly over the last several years (hovering around 1 percent).
But, even if your income level increases your chances of receiving an audit notification from the IRS, steering clear of certain audit “triggers” can help you minimize the chances of being selected. In developing a good tax strategy, it is helpful to know how the IRS singles out tax returns for audits.
The Discriminate Function System (DIF)
Many audit targets are selected through an IRS computer program called the “discriminate function system” (DIF). This screening system uses scoring formula to analyze tax returns and determine which returns are most likely to be inaccurate. The DIF spots inconsistencies (like when a taxpayer with a low income claims a large mortgage interest deduction) and identifies returns that are most likely to have a gap between the taxes owed and the tax liability reported. While the IRS does not explain the statistical formulas that are used to identify which returns have errors, tax experts says it’s no secret that the system is designed to screen for returns that could raise more tax revenue for the federal government.
Missing or Incorrect Information
You may find yourself subject to an IRS audit if there is inconsistent information on your tax return, such as names or amounts. A taxpayer may be audited if an obvious mismatch exists between the information reported and the amounts that appear on the 1099 and W-2 Forms or other income statements. In other cases, individual taxpayers may be singled out for an audit because they are officers or shareholders at a company that is being audited. In addition, wealthy individuals with sophisticated business and financial arrangements (especially those with investments or bank accounts abroad) are being scrutinized even more frequently due to the IRS’s Global High Wealth Industry Group program, which targets rich Americans.
Claiming Tax Breaks
While you do not want to forgo taking advantage of the tax credits and/or tax deductions which you are entitled to, it is important to be aware that claiming certain tax breaks are especially likely to trigger an audit by the IRS. Red flags that can trigger an audit include claiming the home buyer tax credit, home office tax deduction, deduction for 100 percent business use of a vehicle, a large mortgage interest deduction, a large charitable contribution deduction, and a large deduction for unreimbursed employee business expenses (such as travel, meals, or entertainment). The IRS has also been known to scrutinize individuals who have unusual fluctuations in their income, earn a substantial amount of their income in cash, claim large Schedule C business losses while earning wages, or have offshore accounts or other foreign income.
Before you file your tax return, make sure that you have all of the receipts, forms, and other supporting documentation that is necessary to back-up all of the information you’ve provided and the credits/deductions you’ve claimed. You may want to consider contacting a qualified tax professional for advice on how to minimize or manage the types of claims that could put you on the radar of the IRS.