There is an uncanny consistency in the returns that I see the IRS auditing. The process that the IRS goes through to determine whether to audit a tax return is far from random. The IRS knows what to look for, and can spot a return that is prone to having mistakes in it, making you vulnerable.
Keep this in mind about your tax return: it is a map of your finances. And the IRS know the map quite well – after all, they created the map (tax forms). You are filling the map in.
Let’s get into the mind of the IRS. Here is a list of of five items that are red flags to an IRS audit:
1. Returns that are self-prepared. My only evidence of this is what I see – my clients that are audited usually prepared their own tax return. I do not know if the IRS strategically and purposefully targets self-prepared returns, but it sure seems that way. And thinking about it, it makes sense. CPAs. attorneys, enrolled agents – professionals who are well-versed in the tax code and return preparation – may have less errors on a return.
2. Returns that are illogical. Remember that a tax return is a map of your finances and the IRS is the map reader. Here is an example: If your household income is $46,000 a year, but you deduct $18,000 in mortgage interest, $4,000 in real estate taxes and $2,000 in charitable contributions – a total of $24,000 in expenses – the IRS could likely wonder how these expenses are being paid. The income to debt ratio is too high.
Think about it. That $46,000 of income is pretax – you actually brought home, say, $36,000 after taxes and deductions (equal to $3,000/month). The expense deductions on the return for mortgage interest, real estate taxes and charity totals $2,000/month. That leaves $1,000 for food, clothing, utilities, car payments, medical expenses, gas, insurance…and possibly an IRS audit because that budget may be appear unreasonable to the IRS. To an IRS auditor, something is illogical on the tax return – are you making more and not reporting it, or deducting expenses you did not pay? Now, there may be explanations, and they can be provided – but you could be on the IRS’s radar.
3. Schedule C losses. This can go hand-in-hand with the tax returns not being logical. If you are self-employed and show a loss on your tax return on Schedule C, questions can arise in the mind of the IRS: How are you funding the loss? How are you paying living expenses if you are losing money? Schedule C losses offset other income on a tax return, lowering taxes and creating what can often be a significant tax benefit. It makes the IRS curious.