Due to the COVID-19 pandemic, U.S. taxpayers were given extra time to get their 2019 taxes completed this year. The IRS automatically extended the income tax filing deadline to July 15, 2020, and that extension also applied to all payments that would have ordinarily been due on April 15. Taxpayers still have the option of filing for an extension to October 15, if they need more time to submit their 2019 tax return.
Although the IRS is auditing fewer returns than in the past, the agency uses computer algorithms to spot inconsistencies and potential errors. Also, keep in mind that the IRS can make adjustments and propose additional taxes due even without conducting an official audit, through the use of computer-conducted matching notices.
In determining which taxpayers to audit, IRS computers compare a taxpayer with other similarly situated taxpayers to decide whether they fall within a “normal” range for certain expenses, deductions, or credits. With that in mind, here are some reminders of typical discrepancies that trigger interest from the IRS.
- High Earnings
Earning a lot of money is still the No. 1 red flag for the IRS—especially if the amount deviates from previous years. For example, if your income is between $1 million and $5 million, the audit rate leaps from an average of 0.45% to 2.21%. That percentage jumps to 6.66% for returns of $10 million or more.
- Unreported Income
This is where a sound filing system (or that of your accountant) is critical. It can be easy to overlook forms, especially when many of them are sent digitally. Keep in mind that all the forms you receive, such as your 1099-MISC, 1099-INT, and W-2 from work, go to the IRS. In other words, if there is a discrepancy between what you report and the information that was reported to the IRS by third parties, the discrepancy could automatically trigger a “matching notice” (CP2000). Keep a checklist of all the forms you expect to receive and check them off as you receive them. To be extra safe, it is always a good idea to request your “Wage & Income Transcript” from the IRS each year, which contains a list of all of the information returns that the IRS received for you (e.g., W-2, 1099, 1098-T, etc.).
What about that additional income you earned on the side? If someone hired and paid you, let’s say, $600 for extra work you did, you are legally required to report it— and you will need to pay both income taxes and self-employment taxes on it. Also, remember that only the self-employed can deduct unreimbursed job expenses. If you are an employee, you can no longer deduct unreimbursed expenses like you could in the past.
- Self-Employed Income
If you are self-employed, you can claim a deduction for expenses you incur in the course of running your business. From years of experience, the IRS knows that self-employed individuals often claim excessive deductions. It also recognizes that some do not report all of their income. If you are a sole proprietor reporting at least $100,000 of gross receipts on Schedule C, or you run a cash-intensive business (hair salons, restaurants, transport services), you may be at higher risk of an audit.
- Sizable Charitable Contributions
Since the passage of the Tax Cuts and Jobs Act (TCJA) of 2017, charitable donations are one of the only tax deductions you can take. In order to claim this tax break, you must itemize your deductions, but it only makes sense if all of your deductions exceed the standard deduction, which is $24,400 for married couples and $12,300 for single filers. Returns that claim a large amount of itemized deductions, such as charitable contributions, will attract more IRS scrutiny. For that reason, many taxpayers take advantage of a provision that allows them to bunch their charitable contributions. You can combine two years’ worth of donations in one year to reach the deductible threshold, but you can’t exceed 60% of your adjusted gross income for cash donations. Again, IRS analytics will compare your return with your income level to arrive at an amount that other taxpayers at your income level can typically donate. Keeping all of your donation documentation is critical.
- Earned Income Tax Credit
The Earned Income Tax Credit (EITC) is available to low- and moderate-income taxpayers who meet specific requirements. Since refundable credits such as this are so prone to abuse, the IRS carefully scrutinizes returns that claim the EITC. Additionally, if deductions or credits on your return are larger than makes sense for the amount of income you are reporting, the IRS may want to take another look at your return.
- Consistent Deduction of Losses
The IRS will be suspicious of year-over-year losses for a business. It likes to see businesses that generate a profit at least three out of every five years. If you are outside of this threshold, be prepared to back up your losses with sufficient documentation that substantiates your losses. You may also need to substantiate the fact that the activity you’re carrying on is in-fact a business, rather than a hobby.
- Early Payout From an IRA or 401(k) Account
The IRS wants to ensure that those with traditional IRAs and 401(k)s are accurately reporting and paying tax on distributions. If you take money from these accounts before age 59½, unless exceptions apply or you properly roll the funds over to a new retirement account, you could also be subject to a 10% penalty.
There are many other red flags for the IRS, including rental loss claims, business travel expenses, and common math errors, but the common theme is that you must keep all supporting documentation. While it’s important to understand these red flags, also keep in mind that the IRS audited only 0.4% of all individual tax returns in 2019, and most of those were by mail.
While no one likes to think about it, there may come a time when the IRS requires information from you. Just because the IRS notifies you of an inquiry, however, does not mean that you – or your business – have done anything wrong. You have every right to defend yourself, but you will need a sound strategy. Read our free e-book: Your Right to an IRS Defense Strategy
Do you have questions about this blog or other tax services or IRS related issues topics? Please contact the tax team or IRS Defense Service Manager Naveid Jahansouz at 972-818-5300.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.