5 Red Flags to Avoid on Your Tax Return
Feb 27, 2014 | Rick Rodgers, CFP
One of the biggest fears people have is receiving an audit notice from the IRS—it ranks right up there with being diagnosed with a life-threatening illness. Of course, the IRS does nothing to alleviate this fear, because the more frightened you are, the less likely you will be to cheat on your taxes.
The IRS audited one out of every 104 tax returns in federal fiscal year 2013. It’s becoming increasingly evident that the greater your total income, the more you’ll attract the agency’s attention. Last year, the IRS audited about 10.85% of taxpayers with income greater than $1 million. The audit rate dropped to 0.88% for those with income less than $200,000.
Some of the audits were taxpayers pulled at random. The rest of the returns are selected for examination in a variety of ways.
Here are 5 things on tax returns that catch the attention of the IRS and ways you can minimize your chances of being audited.
1. Large itemized deductions
The IRS has established ranges for the amount of itemized deductions based on a taxpayer’s income. Deductions that exceed the statistical “norm” for a given state and region may be red-flagged for a closer look.
This does not mean that you shouldn’t take legitimate deductions. Your deductions could exceed the IRS range due to high medical expenses and large charitable contributions. Take all valid tax deductions—just be sure you keep your backup documentation.
2. Self-employment income
The IRS believes that the vast amount of underreported income occurs among the self-employed. Self-employed taxpayers are audited by the IRS far more frequently than those who receive a W-2 for wages.
People who are employed by others and receive W-2 income but also run a business that reports a loss are especially high on the IRS radar screen. You will need to be able to prove you are operating a business with the intention of earning a profit and not just trying to write off the expenses of a hobby.
You will need to be able to pass both the “passive loss” and “hobby loss” rules in order for the deductions to stick.