Part of the fun of watching Family Feud is hearing the responses contestants give to seemingly easy survey questions. In March of this year, the personal finance website WalletHub conducted a survey of 200 taxpayers, asking them what they would rather do than file their taxes. Some of the top responses included serving jury duty, swimming with sharks, spending a night in jail, and drinking expired milk. The survey also found that 15% of taxpayers ranked getting audited as their biggest fear on April 15. Whether or not this fear is well-founded is a completely different story, given the complexity of the federal tax code and the multiple state and local income tax codes, but there are many common red flags that can trigger an IRS audit.
Mistakes and Omissions
One of the most common ways taxpayers encounter IRS audit activity is through a letter that shows up at their home or place of business. Correspondence audits, or letter audits, as they are commonly referred to, are often used to cross-reference IRS data in its Individual Master File, or IMF, which is collected from various federal agencies throughout the year. For most taxpayers, income is reported on federal Forms W-2 or 1099, which are filed with the IRS every January along with other reportable data. Then, when we as individual taxpayers file tax returns later in the year, we reconcile what the IRS has in its system with any other income and available tax deductions and credits.
Though math errors are not as common as in years past, since most taxpayers use some kind of software, mistakes still happen, and they can easily trigger an IRS notice. Believe it or not, the IRS can make mistakes as well. It is not-so-well known that the IRS Master Files rely on legacy systems that are in desperate need of an update. Long story short, while accepting IRS changes on a notice is always an option, it is a good idea to review any proposed IRS changes with a qualified professional before doing so.
While some IRS notices are triggered by simple mismatches or mistakes, others arise when deductions appear unusually high or unsupported.
Aggressive Tax Deductions
This is a huge issue for business owners and individuals who itemize on their tax returns. Although the IRS doesn’t have a record of business expenses or itemized deductions in the same way it has records of reported income, it does have multiple years of statistics on over 100,000,000 taxpayers and knows, in general, what is average for a given industry or expense category. What can seem like a huge red flag in one situation may seem normal depending on the context.
That context matters because a business owner is allowed to deduct all ordinary and necessary business expenses on their tax return, so even though a certain amount may be outside the norm, it isn’t necessarily a red flag. However, with the knowledge in its possession, the IRS can make a fairly quick judgment about whether an amount is realistic or not. For example, if a taxpayer lists rounded-off numbers for expense amounts, the IRS may take a closer look, possibly triggering an audit. Conversely, an individual could give 20% of their income to charity each year, and it could happen to be an even number, as long as it is substantiated by receipts and donor acknowledgment letters. In summary, substantiation is everything.
Two deductions that often require especially careful recordkeeping are business vehicles and home office deductions. Owning a company car isn’t itself a red flag, but claiming unusually high amounts of business use, or having one car that is parked at the business owner’s house at night, can be if the business owner doesn’t exclude the personal-use portion by keeping track of business and personal mileage driven. A home office must have regular and exclusive use, among other requirements, to be deductible, meaning a dining room table cannot be claimed if it is ever used for family dinners.
Substantiation of Charitable Donations
Charitable donations are another area where substantiation matters. For an individual or business owner to claim a charitable donation, donor acknowledgment is generally required from the charitable organization. But what happens in the case of donations that are hard to value, like donations of household goods to a thrift store? In this case, the IRS allows a taxpayer to deduct the item’s fair market value, determined as if it were sold at the thrift store. This can be confusing because it is a situation where the IRS asks an individual to assess a value and not confuse it with sentimental value, which can be much higher even when the item itself may not sell for much. Again, substantiation with notes and photos will help protect a taxpayer in the event of an audit.
In Conclusion
While IRS audits can feel intimidating, they are ultimately a mechanism for the federal government to verify compliance with tax law. An informed taxpayer can use this to their advantage by understanding how to avoid potential audit triggers and, if audited, defend their chosen stance with substantiation based on facts and circumstances. As always, please seek tax advice from a qualified professional before making any big decisions.
Alan Dierker, CPA, (adierker@stcpa.com) is a Tax Manager at Schmersahl Treloar. He can be reached at 314.966.2727. Angela Piñon (apinon@stcpa.com) is the Outsourced CFO & Advisory Services Manager at Schmersahl Treloar. She can be reached at 314.966.2727. n
Alan Dierker, CPA, (adierker@stcpa.com) is a Tax Manager at Schmersahl Treloar. He can be reached at 314.966.2727. Angela Piñon (apinon@stcpa.com) is the Outsourced CFO & Advisory Services Manager at Schmersahl Treloar. She can be reached at 314.966.2727.