5 Slam Dunk IRS Audit Red Flags

Because in any given year the IRS is able to select for audit only a small percentage of tax returns, it employs a sophisticated system for choosing which returns to examine and which returns to accept as filed.

The IRS assigns a numeric value to each tax return known as a DIF score. Returns with a DIF score higher than a pre-specified number are flagged and sent to IRS regional examiners for further review and analysis.

The IRS examiners are trained to look for tax return items that indicate a high probability of error or fraud.

These items are known in the industry as “red flags.”

The 5 major red flags IRS examiners look for are discussed separately below.
Home Office Deduction

For most people expenses incurred in maintaining a home are non-deductible personal expenses.

However, if you use a portion of your home for business, you are entitled to deduct the costs related to that portion as a Home Office Deduction.

A Home Office Deductions (HOD) is a red flag because the IRS has determined that many taxpayers (and unscrupulous preparers) have historically used the HOD as a means of converting otherwise non-deductible personal expenses into deductible business expenses.

Thus, IRS examiners will carefully scrutinize all tax returns in which a home office deduction has been claimed.

All other things being equal, your chances of being audited are greater if you claim a HOD than if you don’t claim one.
Job Expenses

If you work for someone else and receive an annual Form W-2 showing the amount of wages you received and taxes withheld from your wages during the year, you are entitled to take a deduction for expenditures you made during the year in connection with the performance of your job only if the following three conditions are met,

the total of all such expenses exceed 2% of your Adjusted Gross Income (AGI);
the expenditures were “ordinary and necessary;” and
the expenses were not reimbursed or reimbursable by your employer.

Like the HOD, Job Expense (Employee Business Expense) which is claimed as an itemized deduction on Form Schedule “A,” is a category of expense than lends itself to abuse.

Some taxpayers – usually traveling salesmen and commission based employees – will claim as a deduction various outlays that are not reimbursed by their employer.

The IRS starts with the assumption that if an employer doesn’t reimburse a specific expenditure made by the employee in the conduct of his or her work, that expenditure is probably not a true job expense and, therefore, absent additional proof is probably not deductible.

Consequently, the mere existence of a Job Expense will cause an IRS regional examiner to more carefully scrutinize a taxpayer’s tax return.

This, of course, means that a tax return containing a Job Expense deduction is more likely to be audited than one that does not contain the deduction.

We have been called in to assist many taxpayers whose returns have been selected for audit solely because of an excessive Job Expense deduction.

And we have seen several tax preparers prosecuted for suborning a taxpayer’s claim of a fraudulent Job Expense deduction.
Rental Losses

Rental losses are subject to a number of complex rules of which even seasoned taxpayers sometimes run afoul.

The rental activities of most taxpayers will be considered passive and, therefore, the rental expenses associated with these activities will be deductible only to the extent of the rental income generated by them.

Taxpayers with passive rental losses who meet certain conditions are permitted to deduct up to $25,000 of excess rental losses. The $25,000 passive loss allowance is phased out for taxpayers with modified AGI exceeding a specified amount (roughly $150,000).

Some taxpayers by virtue of the time they spend managing and running their rental operations (the time spent is called “material participation“) will be considered to be in the business of renting real property (as opposed to passively renting real property) and these Real Estate Professionals are entitled to deduct their rental property losses in full.

In order to determine whether or not a particular taxpayer is in fact a material participant in his rental operations, the IRS requires the taxpayer to have spent a specified number of hours during the year in activities related to the management and operation of the rental property.

IRS regional examiners are trained to scrutinize tax returns in which taxpayers are claiming rental loss deductions greater than the $25,000 passive loss allowance.

If a taxpayer is a full time employee or is self-employed, the IRS deems it unlikely that he or she will have had the available time to materially participate in a particular rental activity.

Consequently, these taxpayers should expect their tax returns to be highly scrutinized and probably audited.
Schedule C Expenses

Another area of historic abuse is the claiming by taxpayers of business deductions in excess of business income.

Taxpayers use Form 1040, Schedule C to do this.

If you are running a legitimate business and have a reasonable expectation of turning a profit, you may deduct the ordinary and necessary business expenses you incur in connection with operating that business.

Taxpayers who are employed by others (i.e. who receive a W-2 at year end) and who also claim a loss from a Schedule C business operation are likely to find their tax returns audited by the IRS.

We have seen taxpayers claim Schedule C expenses of more than 100 times the gross income derived from the enterprise; claim deductions on form Schedule C in a year when no income was reported as having been received; and attempt to classify their hobbies as businesses thereby converting otherwise non-deductible personal expenses into deductible business expenses.

In many if not most of these scenarios the taxpayer was represented by a purportedly qualified and scrupulous tax preparer.

Because there is so much abuse in the Schedule C loss area, we have adamantly recommended that taxpayers who are conducting a legitimate, for-profit business incorporate that business or form an LLC.

The mere reporting of businesses operations on Schedule C rather than a separate corporate tax return increases a taxpayer’s chances of being audited 50 fold.
Charitable Contributions

The last of the red hot 5 is charitable contributions.

This deduction has been historically abused by taxpayers because of two reasons:

The documentation requirements have been lenient; and
Taxpayers are entitled to claim a deduction for the fair market value of property they donate.

The IRS will scrutinize returns that include disproportionately large charitable contribution deductions.
Common Threads

Observant readers will have noticed two common threads running through the five items discussed above.

First, each of these items requires a subjective judgment to determine whether and to what extent a deduction is permitted. The more subjectivity involved, the greater the likelihood of mistake or outright abuse.

Second, at least with respect to the first 4 items, these deductions tempt taxpayers and unscrupulous tax preparers to try to convert personal, non-deductible living expenses into deductible expenses.
Final Thoughts

If you have legitimate home office expenses, job expenses, currently deductible rental losses, Schedule C losses and/or charitable contributions, you should consider the following before claiming them on your return:

Are there are other items on your current year tax return or your last 2 years tax returns that you do not want the IRS to scrutinize? If the answer is yes, you might consider foregoing claiming any of the above deductions to avoid triggering of an audit;
What is the comparative value of the deduction? Taxpayers should weigh (preferably with the help of a qualified CPA, lawyer or IRS enrolled agent tax preparer) the benefit of the deduction against the costs (monetary and psychological) that would be involved should the deduction trigger an audit.

If you do decide to take one or more of the above deductions, there are several things you can do to dilute their red flag status.

Timely file your return;
Use a recognized software program to prepare and print your return;
File the return electronically;
Have a respectable CPA, tax lawyer or IRS Enrolled Agent sign your return as tax preparer; and
Attach explanatory statements to your return where necessary.

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