IRS Audit Red Flags You Should Know

Financial wellness is not a one-size-fits-all concept, and it can take different forms throughout various life stages. For individuals in their 20s to 60s, financial stability often revolves around income tax management, building retirement savings, and navigating the complexities of personal finance.

In this light, being aware of potential Internal Revenue Service (IRS) audit triggers can make a significant difference in preserving your financial health. The IRS has its ways of spotting unusual patterns in individual returns, which could lead to audits if left unaddressed. With this article, we’ll dive into seven red flags that can increase the likelihood of an IRS audit and offer some practical advice for mitigating these risks.

You Claim a Loss on Schedule C:

The IRS Schedule C (Profit or Loss from a Business) is a form commonly used by sole proprietors, independent contractors, and individuals with 1099-MISC or 1099-NEC forms. While the IRS understands that startups may incur losses for the first couple of years, they might scrutinize losses that offset your wage income or qualify you for an Earned Income Credit (EIC).

To avoid raising suspicion, provide thorough documentation of your business expenses and ensure they align with industry standards. If you can demonstrate the legitimacy of your losses, you may allay the IRS’s concerns.

You Work in a Cash Industry:

Cash-based industries, such as restaurants, bars, or tip-earning occupations, often present an increased risk of IRS scrutiny due to their inherent lack of transparency. The IRS may question the legitimacy of your income if you cannot provide substantial evidence to support it.

To minimize this risk, consider keeping a detailed cash journal that chronicles your daily transactions. This documentation could prove invaluable should an audit arise and help dispel any doubts surrounding your reported income.

Your Income and Expenses Are Unusual for Your Neighborhood:

The IRS has switched to a computerized audit system that compares individual income levels with those in their neighborhoods. If your income is significantly higher or lower than what is typical in your community, the system may flag it as unusual and warrant further investigation.

This aspect of the process may seem arbitrary, but it underscores the importance of understanding your financial situation within its broader context—namely, the local economy and average incomes.

Income Level Audit Rates:

The IRS Data Book shows that high- and low-income groups have the highest audit rates. This fact suggests that individuals with extreme income levels are more likely to face IRS scrutiny.

Although this data may seem unfair, it emphasizes the importance of accuracy in reporting your income. Ensuring that your returns are as accurate as possible can help minimize the likelihood of an audit regardless of your income bracket.

Random Audits:

While the majority of audits are conducted due to suspicious activities on a return, the IRS also conducts random audits as a means of keeping taxpayers on their toes. Although random audits can seem arbitrary, they still emphasize the importance of accurate and honest reporting.

Claiming Earned Income Tax Credit (EITC):

The EITC is a tax credit for low-income individuals, often those with children, that can amount to several thousand dollars if your earnings are near the poverty line. Unfortunately, it also attracts tax fraud—25% of people claiming EIC should not receive the credit, according to IRS estimates.

To avoid potential audits associated with this credit, ensure you qualify for and accurately claim the EITC. Proper documentation, such as W-2 forms, paycheck stubs, and other relevant financial information, can help prove your eligibility and lower the likelihood of an audit.

Handling an Audit:

In the event of an audit, having good records and filing an accurate return is your best defense. The IRS generally demonstrates leniency toward honest mistakes if you can provide a reasonable explanation for why you believed your return to be correct. Furthermore, audits often start with a specific question about a particular item; being able to support your claim can help prevent the process from escalating.

It’s essential to keep your tax records for at least three years after filing your return or the tax filing deadline if you file late. For additional peace of mind, consider digitally storing your documents in the cloud indefinitely.

Being aware of these IRS audit red flags and taking proactive measures can help safeguard your financial health. By maintaining accurate records, understanding your income within its context, and seeking professional guidance when needed, you can confidently navigate the complexities of personal finance and minimize the risk of an IRS audit.