The end of the year is nearly here, which means consumer spending is in full swing, and people in general are acting a little bit cheerier than normal. However, that cheeriness could disappear once the calendar ticks over to January, because it officially means tax time is just around the corner.
Preparing your taxes isn't a lot of fun -- according to the Pew Research Center, 72% of Americans believe the federal tax code is too complex. For instance, the Tax Foundation found that the U.S. tax code is approaching 10.1 million words in length, not counting the lengthy court documents that help describe some of the tax laws on the books. Furthermore, the instructions to complete a basic Form 1040 are more than 100 pages long.
Yet for all the grief that preparing our taxes gives us, more often than not it's worth it. Most Americans wind up netting a refund from the Internal Revenue Service, with the average refund last year totaling more than $2,700. For most Americans that's a nice chunk of change that could go toward paying down debt, starting an emergency fund, or adding to an investment account.
Nine factors that increase your chance of a tax audit
But for some American taxpayers, it's not the preparation process that's a headache -- it's the potential of being audited by the IRS. Though just 14% of American feared being audited by the IRS in a Feb. 2016 Rasmussen poll, and historically the IRS only audits about 1% of all returns it processes, there are some clear red flags the federal tax authority looks for when processing returns that'll give you a higher chance of being audited. There is no way to guarantee you'll avoid an audit, nor a surefire way to assure you will be audited, but if any of these situations sound familiar, it would be wise to have all documentation and your ducks in a row in case the IRS comes calling.
1. You filed a paper return
Possibly the easiest way to draw an audit from the IRS is to file a paper return. Paper returns give you a much greater chance of making a math error than online software, and even something as simple as illegible handwriting can send your tax return to the pile of those getting a closer inspection. According to TurboTax, paper returns have a 21% error rate compared to just 0.5% of e-filed returns. That's a 41-times-greater chance of making an error and thus being audited by the IRS.
2. You claimed a home-office deduction
Probably one of the most abused tax deductions is the home-office deduction used by people with home-based businesses. While you may think that taking a home-office deduction is a guaranteed tax audit trigger, that's not the case. However, the IRS will look for deductions that don't make sense. Generally speaking, the home-office deduction is only allowed for space dedicated entirely to your work and not your personal life. Thus, if you clam the largest room in your home as your office, but this is also the same room you and your friends watch football in on Sundays, it could draw the attention of the IRS.
3. You received the EITC and/or have no adjusted gross income
Believe it or not, low-income folks are considerably more likely to draw tax audits from the IRS than middle-class individuals or families. Individuals and couples with no adjusted gross income are occasionally put under the magnifying glass due to the fraud associated with the Earned Income Tax Credit (EITC). The IRS estimates that between 21% and 26% of EITC payments made each year are fraudulent, while the Treasury Inspector General for Tax Administration found that the IRS made $15.6 billion in erroneous EITC payments in 2015. In the upcoming year, the IRS will be delaying the tax refund checks of EITC recipients in an effort to reduce the amount of inherent fraud with EITC payments. Though only 1.8% of returns in 2014 reported no adjusted gross income, 5.26% of those were audited by the IRS.
4. You make more than $200,000
Conversely, if you earn a lot of money you'll also fall on the IRS' radar. The IRS clearly has more to win by finding errors in high-income tax returns than those with low income, so it does tend to focus its efforts on higher-income individuals and couples when performing audits. In 2014, there was a threefold jump in the audit rate between the $100,000-$199,999 adjusted gross income range and the $200,000-$499,999. Furthermore, audit rates for those earning more than $1 million, $5 million, and $10 million were 6.21%, 10.53%, and 16.22%, respectively, in 2014.
5. You report a laundry list of Schedule C losses
For the self-employed, filing a Schedule C can be either a savior or a red flag for the IRS. Reporting a loss is expected from relatively new businesses, but write-offs that result in ongoing losses could draw the attention of the IRS. According to NerdWallet, the IRS considers a business to be engaged in for-profit activities if it reports a profit in three out of the last five years. A business that regularly posts losses year after year may be classified as a hobby, which would wipe out the net loss on your original tax return and leave you to pay additional taxes, penalties, and interest.
6. You claim too many business expenses
Additionally, the IRS will look to see if your business expenses are considered "ordinary and necessary." For example, if you pay rent for your business, or you're an accountant and need to buy tax software, these are ordinary and necessary expenses to do your job. However, if you buy new cookware and are a tax professional, that's not a necessary expense that you can write-off. The easiest way to determine if it's a deductible expense is simply to answer the question, "Is this good or service necessary for me to do my job?" If the answer is yes, then you probably can write it off.
7. Your charitable contributions are disproportionately high compared to your income
Giving to your favorite charity or charities is a double-bonus for taxpayers. Not only does it further a cause you believe in, but it also provides a deduction that's proportionate with your highest marginal income tax bracket. Thus, it's a deduction that tends to favor well-to-do Americans. What'll draw the attention of the IRS and possibly trigger an audit is if you're donating an abnormally large amount of your income annually. For example, if you make $50,000 annually, but are claiming $15,000 in charitable contributions, that's liable to draw the attention of the IRS. As one extra note, make sure you have documentation for every charitable contribution you make in case the IRS comes calling.
8. You failed to include Form 1099 income
If you're thinking about overlooking any of the income you received as a freelancer or via Form 1099, don't! Nonwage income earned via Form 1099, such as freelance income, dividend income, or interest earned, is automatically reported to the IRS, meaning that if you fail to include this income it'll probably be just a matter of time before the IRS catches on. If you fail to report income, your chance of an IRS tax audit go way up.
9. Your numbers look a little too perfect
Finally, if your tax figures look a little too perfect, it could result in a call from the IRS. For example, if you don't have the appropriate documentation and your business expenses total a round number such as $1,500, it could be a red flag. It's pretty uncommon for expenses, deductions, and income to all land on easily added and subtracted whole round numbers. If this happens on your tax return, the IRS may question it.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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