How the IRS Chooses You for an Audit

Now that tax season is under way it is time to consider audit proofing your tax return. Small steps you take today can save you time, money and headaches later. 

First, the good news. Audit rates have been falling the past decade by a substantial amount. For 2018, the IRS audited .45% of individual returns, down from .59% in 2017. IRS funding cuts between 2011 and 2017 cost the IRS 27% of its enforcement staff (an 18% decline in tax examiners and a 40% reduction in revenue officers), according to the Government Accountability Office. 

The reduction in IRS enforcement efforts does not mean the IRS doesn’t have the authority to aggressively deal with tax scofflaws. The IRS still carries a big stick and focuses on certain problem areas. Taxpayers claiming the earned income credit faced an audit rate in excess of 1% in 2018, compared to the overall audit rate of individual tax returns the same year.

 

Two Kinds of Audits

There are two types of tax audits: the correspondence audit and field audit. 

• Correspondence audits: Of the nearly 1 million tax returns audited in fiscal year 2018, over 75% were correspondence audits where the IRS simply sent a letter to the taxpayer outlining where the IRS records differ from the return filed. If the taxpayer disagreed with the IRS the taxpayer had an opportunity to point out the IRS error. If the taxpayer was in error, she could then arrange payment. 
• Field audits: The field audit is what most taxpayers think of when they think of an IRS audit. In the field audit the IRS reviews detailed financial transactions of the taxpayer. This can happen at the IRS office, the taxpayers business, the office of the accountant of the taxpayer and even via mail and email. 

Correspondence audits can lead to a field audit. If the information triggers the IRS system a taxpayer’s return may be flagged for additional review. This is why it is so important to file an accurate return the first time.

 

 

Correspondence audits rarely take long to complete. The information required to fix errors is clearly outlined (usually), making it easy for the taxpayer to resolve the issue with a letter or two. 

Field audits are not so fast. A field audit can take anywhere from a few months to years to finalize. Field audits can also come in the exceptionally virulent kind where the IRS drills deep into the paperwork of the taxpayer. This can happen when the IRS is concerned significant amounts of unreported income and/or over reported deduction or fraud are involved. Periodically the IRS conducts compliance audits that are nothing short of a proctology exam on the taxpayer. Compliance audits are picked at random to help the IRS figure out where taxpayers mess up. Pray you never get one of these audits from hell.

Even a correspondence audit is enough to make a person’s heart miss a beat. Letters from the IRS never are a sign of good news so we will now turn to avoiding the whole unpleasant mess in the first place.

 

Avoiding a Tax Audit

Income is a major determinant of audit risk. Taking the earned income credit is another large risk. (About 35% of all individual tax audits involve the EIC.) These risk factors are hard to avoid. Reducing income just to lower your audit risk is akin to killing the patient to cure the disease. The same applies to tax credits like the EIC; if you qualify you should take the tax credits you qualify for. 

Income and tax credits take a lot of heat, but it doesn’t acknowledge what is going on under the hood. As the chart below shows, taxpayers with zero or negative income have a high audit risk, at nearly the level of those earning $1 million to $5 million per year. Why is this?

Taxpayers with zero or negative income achieve this with deductions and/or credits. Zero and negative income taxpayers probably also have small business income reported on Schedule C or income properties on Schedule E. What the IRS doesn’t tell us is some of these audits involve taxpayers with $1 million or more in revenue and expenses even greater than the income. 

Taxpayers getting audited the least have an adjusted gross income between $100,000 and $200,000. It is a nice spot to aim for if an IRS audit is your concern. Those with an AGI of $10,000,000 or greater face the highest risk of audit, at over 6.66%. 

 

Audit Risks You Can Control

While income and tax credits are mostly out of your control (unless you choose to forgo income or tax credits you qualify for), there are several things you can do that increase your audit risk several fold. The first, and most common, is mismatched information. 

Undisclosed income: The IRS gets loads of financial information on you each year. Forget to include a prize or gambling win and you are virtually guaranteed a letter from the IRS. The same applies for dividend and interest income reported on a 1099. Business owners frequently get a 1099-K for credit card payments for goods or services sold. You need to report at least this amount of income or attach a good explanation to the return to account for the discrepancy. All 1099-MISCs and 1099-Ks added together is the minimum you should report as business income on your return. Any lesser amount will require an adjustment to the originally filed return (more on this below) or dealt with later when the IRS contacts you.

S corporation basis: A growing area of audit risk is basis. If you get a K-1 from a partnership or S corporation you need to track basis. For an S corporation you need to track both stock and debt basis. Many individual returns now require the basis statements be attached. If there is an error it can eventually lead to a full-blown field audit. The time spent now building an accurate basis statement is less than the time it takes to fight an audit, plus the costs of defending yourself in an audit. Basis is the latest IRS focus. Hire a tax professional if you need help with this. It’s that important.

Itemized deductions: With the standard deduction much higher now and state and local taxes capped at $10,000 and miscellaneous deductions, subject to 2%, eliminated, it is hard to itemize unless you either have a large mortgage or donate a lot to charity. Low interest rates and a reduced limit on the amount of mortgage interest eligible for deduction on Schedule A leaves charitable deductions as the one line that plays a large role in helping you itemizing under current tax laws. However, a large charitable deduction on Schedule A increases audit risk significantly. If you have a business or own income properties you might have a planning opportunity to deduct charitable giving as sponsorships or promotional expenses for the business or income property. You can read more on this strategy here and here.

 

 

Deflecting an Audit

Sometimes there is no way around it. No matter what you do, it will be an audit risk. Not claiming a large charitable deduction is foolish; you still take the deduction. Sometimes information returns (1099s, W-2s, K-1s, etc) are wrong and the IRS has the bad information. Now what do you do?

There are two lines of defense and I use both liberally in my office that leads to an audit rate among my clients of under .1%. This keeps both clients and friendly tax professional happy. (The best audit is the one I never have to fight.)

The first line of defense is Form 8275: Disclosure Statement. Yes, you intentionally squeal to the IRS on yourself. It sounds counter-intuitive, but it really works. If you do the leg work to determine the correct way to report data on your tax return the IRS knows it is not low hanging fruit. In over 30 years of practice I never once had the IRS audit on a return I filed with Form 8275! And I file as many as 50 of these animals per tax season.

Coupled with the first line of defense is line two: attach documentation to the e-filed return. As many as a third of the returns I file in my office have some sort of attachment. My office does focus on very large and business returns so attachments are required more often. Required or not, I frequently attach documentation along with Form 8275. Here are a few examples:

Example 1: Several years ago a client received a large inheritance and donated all of it to his church. The contribution was larger than his income. Past experience said this client was in the cross hairs of the IRS for an audit. Not only did I attach copies of the church receipts and copies of cancelled checks, but a copy of the inheritance paperwork as well. The client never heard a word from Revenue. If he was audited the IRS never let him know about it. They had what they needed for a narrow audit. This avoided a larger audit that would certainly have included his business.

Example 2: This example happens to more clients than you think. An incorrect 1099 or K-1 comes in and the taxpayer can’t get it fixed. If you report the correct amount the IRS computer will blow a gasket and trigger an audit (and let’s hope it is a correspondence audit only). I recommend you report the incorrect information so that it matches the IRS computers and make an adjustment elsewhere and attach a disclosure with documentation to the return. If it is a business that receives an incorrect 1099-MISC with additional income, report the income and then take a deduction as an adjustment and disclose. If it is a gambling win you can make the adjustment same as a gambling session. The same applies to prizes won. Be sure to always disclose and attach documentation. Keep good records in case the IRS has questions!

 

It is impossible to completely avoid a tax audit. They happen. You can, however, reduce your chances of an audit several fold by following the few simple rules above. 

Keep good records! If you are unfortunate enough to face an audit, nothing shortens the audit faster than good records. When the taxing authority realizes there is no low hanging fruit they lose interest fast. Clean records also avoid a deeper look into your finances. You just don’t want the hassle.

 

More Wealth Building Resources

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QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

A cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

 

[sc_fs_multi_faq headline-0=”h2″ question-0=”How does the IRS choose who to audit?” answer-0=”High income is an obvious indicator for audit risk. However, very low income taxpayers face audit rates nearly as high as those with multi-million dollar incomes due to tax credits used in fraud, like the Earned Income Credit. It is not recommended you avoid tax credits you are entitled to. Instead, fully disclose the proper information with the tax return to lower your tax audit risk.” image-0=”” headline-1=”h2″ question-1=”What triggers an IRS audit?” answer-1=”The number one reason for getting a letter from the IRS is unreported income. Always take care when preparing your tax return making sure you include all income. The IRS already know most of your income. Not including it on your tax return is a sure way to get audited. Other audit triggers are high deductions in comparison to income, small business income and refundable tax credits.” image-1=”” headline-2=”h2″ question-2=”How to prevent a tax audit?” answer-2=”Simple returns have no low-hanging fruit for the IRS to audit. The IRS computers are looking for the unusual, the things that might contain overstated deductions or unreported income. Whenever your tax situation has something unique disclose the issue on Form 8275 and attach any supporting documents. If the IRS does decide to look they may accept the provided documents and explanation without expanding the audit to the remainder of your return. ” image-2=”” count=”3″ html=”true” css_class=””]