IRS audit. These are the words most of us would prefer to avoid if at all possible. Am I right? Here are 7 red flags to help you avoid an IRS audit.
An IRS audit is an examination or review of information and accounts to ensure you’re reporting things correctly and following the tax laws. In other words, the IRS simply double-checks your numbers to make sure you don’t have any discrepancies in your return.
Remember that your W2 and 1099s are all also reported directly to the IRS and computers will compare your data to reported numbers. If things don’t match, your return gets flagged for further review.
Sometimes state tax authorities do audits, too. If you’re telling the truth, and the whole truth, you shouldn’t worry. Nothing is inherently sinister about an IRS audit or state audit. However, if you are consciously cheating the system, you do have reason to be concerned.
Why does the IRS audit?
The IRS conducts tax audits to minimize the “tax gap,” or the difference between what the IRS is owed and what the IRS actually receives. Sometimes an IRS audit is random, but the IRS often selects taxpayers based on suspicious activity. This can be anything from misreporting a number on a W2 or 1099 to creating false Schedule C (business) or Schedule E (rental) information.
The IRS has the right to ask for records and proof of anything you submit on your return. While I’m against deception, lying and tax fraud, I’m also against a taxpayer paying more than they owe. As you prepare numbers for your return, here are seven of the biggest red flags likely to get you an IRS audit.
- Make a math error
- Fail to report income
- Claim high charitable donations
- Report a loss on Schedule C
- Deduct high business expenses
- Take the home office deduction
- Use rounded numbers
1. Make a math error
Mistakes happen. Nobody is perfect. However, mistakes on a tax return can be costly. Make sure to double-check numbers and don’t get distracted when filling out your tax information. Turn notifications off on your phone, turn off Netflix, remove distractions and give your taxes the attention they deserve.
I usually suggest filling out tax return information. Leave it be overnight at a minimum and come back to it the next day. That way you can double-check your numbers with fresh eyes. You can even have a spouse or friend go over it with you to make sure numbers are accurate and there are no math errors.
The IRS can fine you whether or not your mistake was intentional. If you’re unsure how to report something, hire a tax professional.
2. Fail to report income
Want to know an easy way to score an IRS audit? Maybe you already figured it out?!?!
Don’t report income.
Let’s say you are employed as a W2 employee. However, you have a side hustle as well. While you might be tempted to submit only your W2 information and keep the side hustle a secret. This is a big no-no. If you receive more than $400 for your side hustle, you better report the income. This is especially true if you receive a 1099 for any income.
A 1099 reports income from things like freelancing, contract work, stock dividends, stock sales, rent, interest, etc. One type of 1099, the 1099-NEC, typically reports amounts paid to independent contractors.
Well, guess what? The IRS already knows about the income listed on your 1099 because the business or bank sent the IRS a copy. It’s only a matter of time before the IRS catches your omission. Don’t think you can fly under the radar. It can and will lead to trouble and possibly, an IRS audit.
3. Claim too many charitable donations
If you make contributions to charity, you might be eligible for some well-deserved deductions. You can take a deduction for donations to charity if you itemize deductions. Large donations mean you might qualify to itemize. This can include donations to your church, your favorite national or local charity. Just make sure they are a 501(3)c organization and keep the letter reporting your donation.
In 2020, the IRS allows for $300 of charitable donations to be deducted without itemizing! In 2021 that number increases to $600 if you’re married filing jointly. If you’re single, it stays at $300 for 2021.
However, don’t report false donations. Make sure you have the proper documentation and good record keeping to prove your contribution amount. Without proof, don’t claim it. Pretty simple, right?!?!. Claiming $10,000 in charitable deductions on your $40,000 salary is likely to raise some eyebrows or get you an IRS audit.
FYI: time does not count as a charitable donation.
I do know that some taxpayers like to make larger charitable donations. That’s not a problem as long as you keep your receipt (electronic records are fine). I’ve seen the IRS audit charitable donations in particular so be ready.
4. Report too many losses on a Schedule C
This one is for the self-employed. Being your own boss has its perks.
However, if you are your own boss, you might be tempted to hide income by hiding personal expenses as business expenses. Before you write off your new personal purchase, consider the suspicion that too many reported losses can arouse. This is especially true if you do this year after year. The IRS may begin to wonder how your business is staying afloat. If you want to understand business expenses, you might find this IRS publication helpful.
Be ready with records and proof of all your business expenses.
5. Deduct too many business expenses
Along the same lines as reporting too many losses is reporting too many expenses. To be eligible for a deduction, purchases must be 1) ordinary and 2) necessary to your business. A professional artist can claim paint and supplies because these items meet both requirements. A developer who paints for fun might sell a few pieces, but they don’t turn a profit on their art may have a problem defending these expenses.
The questions to ask are: Was the purchase common and accepted in the trade or business? Was it helpful and appropriate for the trade or business? Is it a business or a hobby?
The biggest no-no for business expenses especially as a traveler is taking large travel expenses, taking 100% of all your phone expenses, and taking all your camping/RV park costs. Your lifestyle doesn’t become a business deduction. Depending on your business, you might qualify to take some phone expenses and maybe a few campground or travel expenses. Just be aware that having big losses year after year is not acceptable by the IRS.
6. Claim a home office deduction
Home office deductions raise a big red flag – especially if you’re living in an RV full-time! It may be tempting to give yourself undeserved deductions for expenses that don’t technically qualify.
The IRS defines the home office deduction as part of your home being used “exclusively and regularly for your trade or business.” That means a home office can qualify if you use it for work and work only. I don’t know of too many RVs that have a separate area for business use only. Isn’t there a saying that all things in the RV must have at least 2 purposes?
If you live in a small space, then I highly recommend not taking the home office deduction.
Claiming a home office deduction may be more defensible if you have set off a section of your RV like in a toy hauler or bunkhouse strictly for business use. Be honest when you report expenses and measurements.
7. Using nice, neat, round numbers
In all likelihood, the numbers on Form 1040 and supporting documents/worksheets will not be in simple, clean intervals of $100. When making calculations, be precise and don’t use estimates. Round to the nearest dollar, not the nearest hundred. Say you’re a photographer claiming a $795.56 lens as a business expense; round that to $796, not to $800. An even $800 is somewhat unlikely, and the IRS can ask for proof.
This goes for mileage as well. Don’t guestimate. Track your mileage using an app. Better yet track all your expenses and keep receipts. Keep those records as proof should the IRS come knocking. With records and receipts, you know you are reporting accurate numbers on your return and can hopefully avoid an IRS audit.
Have questions about which business deductions you can take? Download the business deduction checklist today.