Tax season is right around the corner, and while many people are excited about the refund that is coming, others might be worried this is the year they'll be audited.
While less than 1% of tax returns are selected for an audit, several "red flags" could greatly increase your odds of just such an IRS examination. We asked three Motley Fool experts for some common reasons people are audited, and here is what they had to say.
Matt Frankel: The IRS considers large tax deductions, particularly those that are often abused by taxpayers, to be big red flags. A great example of this is the home office deduction.
To take a deduction for a home office, the space must be used exclusively for conducting business. However, many people will try to claim this deduction if, say, they work on their laptop in the living room.
The deduction can add up to quite a bit of money. Whatever percentage of your home's square footage is taken up by your office, you can deduct that portion of your home expenses (mortgage or rent, utilities, etc.) in your tax filing. If you live in a high-cost area, this can easily add up to thousands of dollars.
Other commonly questioned deductions include large or excessively valued charitable contributions (like claiming a bag of clothes you donated is worth $5,000), questionable "business" expenses, and pretty much any deduction that is disproportionately large for your income or personal situation.
Now, if you have large deductions that are legitimate, by all means claim them. If you can back them up, an "audit" will likely be no more than a request for documentation by mail. Just be aware that if you make one of these deductions, the IRS is likely to give your return a closer look.
Dan Caplinger: One surefire way to draw the IRS's attention is to report numbers on your tax return that are different from those on the various information returns you'll start receiving in January. Copies of your W-2 from your employer and 1099s from investment providers go directly to the IRS, so leaving one off your tax return will immediately trigger a red flag from the IRS computers. In some instances, you'll be lucky enough to get off with a simple letter informing you of your mistake and what your tax bill should have been. But if the IRS sees a pattern of bad behavior, the chances of a full-blown audit become much higher.
Unfortunately, you'll often get a W-2 or 1099 that contains errors. To avoid the risk of an audit, it's not enough just to report the correct numbers yourself. You also must have your employer or financial institution file a corrected W-2 or 1099 with the IRS. That can be a huge amount of work, and in some cases the reporting party won't cooperate with you. But most of the time, you'll get the results you need, and that will save you from the much greater threat of facing an IRS examination on your own.
Dan Dzombak: One reason the IRS could audit you is too many round numbers on your filing or other made-up numbers.
Most numbers don't end in round digits, especially not in intervals of $100. Seriously, when was the last time that happened? If your claimed deductions end in round numbers rather than reflecting the true messiness of costs in real life, it's an obvious red flag.
In addition, while the IRS does not reveal how it detects fraud, the agency's computers likely use a mathematical tool called Benford's Law, also called the first-digit law. Physicist Frank Benford showed that in many real-life sources of data, one is the first digit in numbers 30% of the time. The other 70% of first digits follows a predictable distribution.
|First Digit||Percentage of Distribution|
When people make up numbers, generally the digits five and six appear far more often than a real distribution would suggest. If your tax filing differs too far from Benford's Law, it's likely a red flag for the IRS to look at your return more closely and perhaps audit you.
Dan Caplinger has no position in any stocks mentioned. Dan Dzombak has no position in any stocks mentioned. Matthew Frankel has no position in any stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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