Are You an Audit Target?

 In IRS Problems

Having a tax return selected for audit is probably on the top five list of things most people would rather avoid. . .but is it avoidable?

Many taxpayers believe that audits are random and that their own individual risk of being audited is low based on articles that float around the internet and the taxpayer’s own sincerely held beliefs (or perhaps the more appropriate word is “hopes”). Maybe you have read some of the articles that mention a 1% audit rate, that the IRS has cut staff positions due to budget shortages, or that a massive amount of IRS agents are headed for retirement. Or maybe you have read about the shocking cases of celebrities or high-profile individuals serving prison time for evading millions of dollars in taxes. Those articles may give you a false sense of security, and you thus infer that your chances of being audited are low because the IRS does not have enough people to audit everyone, or that the IRS doesn’t care about the “Average Joe” because they’re focused on Wesley Snipes or Bernie Madoff.

While Wesley Snipes or Bernie Madoff articles are great click-bait and thus get the vast majority of media attention, every day ordinary people such as waiters, construction workers, small business owners, and even Uber/Lyft drivers are audited. But what about the IRS’s “reduced staff” and all those retiring agents? Well, this is the new millennium, and the majority of people are selected for audit based on computer algorithms. The IRS has made significant investments in data analytics, machine learning, and artificial intelligence. In addition to the updates in technology, the IRS is expanding third-party reporting to include more parties, transactions, and occurrences every year. As a tax practitioner myself, it seems like most every year I discover that there’s some new type of 1099 that didn’t exist the year before.

All of these advances are making it increasingly easier with each passing year for the IRS to hone in on non-filers, taxpayers that underreport income, and taxpayers that file returns that are out of the realm of normalcy.

So let’s get on with it! Here are some of the reasons that your return might be selected for audit, in no particular order of importance. I’ll discuss five here, but the list is not limited to those mentioned.

Business Losses Year After Year

Let’s put our thinking caps on for this one. Who on Earth would make the illogical decision of operating a business with the goal of losing money? Probably no one. Of course, with most any business, there is a possibility of legitimately having a business loss in a tax year. This is especially true during these challenging times surrounding the COVID-19 pandemic. But if a business continues to lose money year after year, at some point common sense will prevail and the owner will either discontinue it or make some changes to turn things around.

 Here’s why this scenario may result in an audit. The IRS wants to know: is this business “really” losing money or just saying so on the tax return? Is this really even a “business” or is it just a hobby that the taxpayer is engaging in for his or her own personal enjoyment and wrongfully deducting losses on the tax return? This is especially true where a service business is concerned. While with selling goods the price of what you sell may be out of your control, when it comes to services you are generally able to price your services to a degree that a profit is to be expected. And if profits do not result, especially as compared to similarly situated businesses in your industry, your return may be selected for audit.

Reporting an Unusual or Excessive Amount of Certain Business Expenses

Ever heard of a NAICS code? Maybe you haven’t, but if you look at the tax return for your business (or on your Schedule C for a self-employed taxpayer), you will see a 6 digit code that describes to the IRS for statistical reporting purposes the type of business you are in. Maybe it’s manufacturing, providing legal services, or digital marketing. While most taxpayers gloss over this part of the return, it is very important to the IRS. They have access to millions of returns and their computers are able to determine what is “normal” or “expected” based on the size of your business, your tax classification, and your NAICS code. If your business is reporting an expense or expenses that are well outside of the expected range, your return may be selected for audit.

Filing an Amended Return for a Refund

For the average taxpayer, filing an amended return is a rare occurrence. Sometimes a taxpayer may file their original return in January and realize they forgot to include a 1099 that was mailed to them in February, or they may amend for some other innocent or benign reason.

But what about the taxpayers that have “buyer’s remorse”? They file the return and realize they cannot pay the tax later, so they “find” some more deductions after it’s already filed, or they amend to add on a dependent later when they found out no one has claimed their nephew on a tax return and then take the Earned Income Credit and Child Tax Credit for the nephew. The IRS is aware that people try things like this, so amended returns get extra scrutiny.

Have you ever seen an amended return? One of the requirements is to specifically describe WHY the return is being amended and to include all forms and schedules that have changed. The adequacy (or inadequacy) of this explanation, failing to include the changed forms, or reporting new deductions that do not make sense in the context for the original return may result in your return being selected for audit.

Failing to Include All of Your Income

Remember that third party reporting I mentioned earlier? The IRS is privy to many transactions that occur with taxpayers that have the potential to result in taxable income. If you fail to include that income or transaction on your tax return, which has been reported to the IRS by the third party, your return may be selected for audit.

Filing Late or Not Filing at All

Why do you think that taxpayers file late or fail to file? Oftentimes it is not because the taxpayer is intentionally trying to cheat the government. It could be something as innocent as the taxpayer not keeping up with their records adequately, or their bookkeeper quit and now everything is a mess, or maybe there is no tracking of income or expenses at all due to being busy with work, health issues, or family obligations. Whatever the case, a taxpayer that files late or fails to file is generally a good target. How accurate are those reported expenses likely to be in comparison to the person that files on time every year? Can you substantiate expenses that happened two or three years ago? The IRS knows this. If they’re working with less staff, doesn’t it make sense to focus on the cases where they are likely to recover money for the government in the form of assessed tax, penalties, and interest? Tax returns that are filed late or not at all, generally have the worst quality of evidence to support the deductions, so filing late or not at all may result in your return’s selection for an audit.

After reading this, if you feel you might be an audit target, do not stress! Simply fill out the form for a free consultation, and my firm would be happy to help.

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