Have you ever been warned by your CPA that “this could be a red flag for the IRS!”? Fear of those pesky red flags can cause you to overlook or not report legitimate deductions. Don’t think for a minute that the IRS doesn’t encourage and play to your “red flag” anxiety.
At the same time, there are areas you should know that can cause your return to get a second pass through the IRS system. You should be aware of these situations so that you will be sure to have accurate documentation in the (admittedly small) occasion that your tax return has the dubious honor of being selected for audit.
- Taking higher-than-average deductions. These typically are returns with itemized deductions exceeding 40% of AGI. Charitable contributions, in particular those that involve noncash donations such as a vehicle or artwork, are the usual suspects.
- Unincorporated businesses (schedule C), especially if they are cash-intensive such as bars, car washes, and restaurants. If you and your buddies have always wanted to own a restaurant for fun, think twice.
- Unincorporated businesses with revenue greater than $100,000. Neglecting to incorporate is questionable because corporate revenue is more easily traceable.
- Filing a schedule C on your self-prepared return (same for filing your own partnership or corporate tax returns). Non-professional preparers tend to make lots of mistakes and the IRS is on to you! On the other hand, this is an area where you are probably overpaying taxes — is preparing your own business return worth the stress?
- Unincorporated business losses in three out of five years. The IRS wants you to prove that you really are trying to make a profit on your llama farm.
- Rental loss deductions, especially if you claim to be a real estate professional. Real estate pro’s are not subject to PAL rules but if you have another job, you’re almost certainly not a real estate professional.
- Claiming a 100% deduction for a business automobile. The IRS also has an eye out for purchases of heavy cars with tax-favored depreciation, such as Hummers, particularly if late in the year. Unless your business requires a car, it’s pretty unlikely you don’t do a bit of shopping with it.
- Failing to report foreign bank accounts — the IRS is highly sensitive to money held overseas in our post-9-11 world.
- Math errors — if you aren’t using TurboTax or another computer program, triple check the math!
- High income — you don’t have to be Donald Trump to be highlighted. In 2015, people with incomes of $200,000 had triple the risk of audit.
- If an entity reports income paid to you that differs from what you report. This includes gambling winnings, 1099 income, and any other payments that fall under the IRS form “matching” system.
- Large deductions for lavish travel, meals, and entertainment. The standard for a legitimate deduction is “ordinary and necessary”. If a $500 bottle of wine is not an ordinary and necessary expense for your office party, you may want to reconsider that deduction.
- Using a tax preparer who is known to the IRS to have questionable practices (sloppiness and errors, problematic deductions, etc.) In other words, if your preparer is a shady lady, the IRS can review all of her shady clients.
- Claiming a lot of dependents — true story: seven million children disappeared from tax returns in 1987, when the IRS began requiring filers to list their Social Security numbers!
While you don’t want to intentionally wave a red flag, you should never be intimidated into waving a white flag to sacrifice a deduction to which you are rightfully entitled. If you’re not sure, consult with an experienced professional who does not fear standing up to the IRS.