Filing tax returns is often considered to be a daunting task for almost all filers, primarily because of the inherent risk of an audit by the IRS. Despite the fact that IRS Audit does not occur on a regular basis, it is still considered to be an extremely daunting and challenging task for all filers, because it might lead to an irreplaceable loss in terms of repute, and mental exhaustion.
Having an unfavorable audit experience might lead to certain catastrophic repercussions in terms of financial penalties, as well as other possible litigations. Therefore, the best course of action that is adopted by filers is to avoid red flags in audit, as much as possible.
Red flags can simply be defined as aspects in the tax file that might be a cause of concern on the part of the IRS. These red flags need to be closely inspected, in order to avoid IRS Audits as much as possible. These red flags are not limited to a certain event. In fact, they form to be a multitude of various different factors that eventually result in IRS being provoked for a deeper insight into the accounts of a given individual.
What are the red flags that trigger an audit?
The main red flags that mostly trigger IRS Audits are as follows:
- Failure to report complete taxable income
Under a lot of situations and circumstances, it can be seen that individuals tend to miss out on important income. In other words, income earned during the particular year is not always reported in full. However, this is a very major blunder, since income that is received either in a bank account, or via any other means never goes unidentified by the IRS. Therefore, it is important for individuals to ensure that all income, regardless of the magnitude is reported in the financial statements in order to avoid red flags as much as possible.
- Abnormal income fluctuations
Abnormal income fluctuations refer to income thresholds significantly changing from one year to another. In the case where there is a higher income reported in one year, followed by a lower income reported in another year, it eventually raises several red flags on the part of the IRS. Therefore, volatility in the financial statements often results in suspicions on the part of the IRS.
- Excessive deductions, and credits
Regardless of the fact that tax deductions and credits are allowed by the IRS, there is a smarter way to go around it. It is always advisable to only account for those tax deductions that are allowed by the IRS, and not to go overboard with deductions and tax credits. In the case where an individual files for higher than average deductions, it results in triggering IRS to audit the particular account, because it forms solid grounds of suspicion.
- Large charitable deductions
A lot of individuals often claim charitable deductions, in order to reduce their tax liability. Whilst, on one hand, it is allowed, yet in certain situations, a lot of taxpayers do the mistake of deduction more charitable deductions. This often results in suspicions on the part of the taxpayers, since IRS is fully aware of the average amount of charity (and charitable donations) disclosed by a taxpayer with the given stated income level. Hence, it is of primitive importance, on the part of the taxpayers to ensure that all valid charitable donations are disclosed in the financial statements.
- Rental Losses Claims
Mostly, the passive losses that are incurred prevent the deduction of a rental real estate loss. However, there are a few exceptions to this. Normally, the IRS scrutinizes significantly larger real estate losses, which are written off by taxpayers that claim to be real estate pros. Therefore, when filing or claiming rental losses claims, it is of imperative importance to ensure that all relevant documentation is accounted for, and all important information is duly accounted for in the regular tax returns.
- Non-Filing of Tax Returns
Nothing triggers an IRS Audit more than non-filing of tax returns. IRS is super diligent in pursuing individuals who don’t file tax returns on a regular basis. In fact, the IRS uses its directory in order to identify all the individuals that are not regular in tax filing, which then turns to be a significant red flag for the IRS.
- Incorrect Business Claims
For sole-proprietors, and home-office earners, it is a tricky business to ensure that there is proper segregation of home expenses, versus office expenses. Factually, it can be seen that there are several different business claims that are improperly categorized. For example, claiming 100% business use of automobiles is considered to be a big red flag for IRS agents.
- Failure to report gambling winnings or losses
All recreational gamblers are supposed to ensure that their winnings and losses are properly disclosed in the financial statements. Factually, there are important covenants that should be borne in mind when it comes to reporting gambling winnings or losses. All individuals need to report all gambling winnings, or losses, regardless of the volume of the gambling winning or loss itself, because if this is not reported properly, it might result in triggering an audit on the part of the IRS.
- Failure to report Foreign bank accounts
IRS is extremely vigilant about taxpayers’ money that is stashed outside the U.S. Therefore, they place a high degree of importance in order to ensure that all foreign bank accounts are disclosed in the tax returns so that the actual amount of wealth is stored outside the U.S can be ascertained. In case individuals fail to report the foreign bank accounts, it eventually results in a severe red flag on the part of the IRS, and it can eventually result in an audit by the IRS.
- Early Pay-out from an IRA or 401(k) account
The IRS wants to make sure that traditional IRAs and the participants in 401(k)’s and other workplace retirement plans are properly reported, and tax is paid on all distributions. Therefore, all payouts and deductions should be sought after with proper care, in order to remove any confusion or room for error on the part of the IRS. It is important to understand that only allowable deductions should be accounted for, and payouts are deducted at reasonable levels to reduce any remote chance of error or suspicion on the part of the IRS.
- Currency Related Transactions
The IRS mostly gets insight regarding cash transactions that exceed $10,000 and that involve banks, casinos, or any other business-related activities. In the case of cash purchases using a significant amount, the chances for IRS scrutiny are quite considerable. Hence, if there are considerable (and regular) transactions of a higher token size, the chances of IRS scrutiny are quite high.