If I were asked to name three IRS red flags where I saw clients get challenged and usually resulted in a change, this category might top my list. Home office deductions and the associated expenses for individuals whose company has a primary location somewhere else tends to trap taxpayers who are not completely familiar with the nuances of the code. Many people misinterpret the rules associated with the deduction while others simply abuse or try and game the system. The most difficult arguments to make with the IRS are with those taxpayers who receive a W-2 and are someone else’s employee while still claiming a substantial home office deduction for the use of their business. It is really hard to make an argument, absent special circ*mstances, that an employer either does not provide a suitable primary office location for the employee’s position or does not reimburse them for the out-of-pocket-costs associated with setting up a home office. Furthermore, some occupations statistically do not normally require home offices. It therefore seems obvious that IRS red flags may be raised when you are in one of these professions and claim a home office deduction on your tax return. Just be careful when claiming the deduction and always keep good records (including photos of the office environment). If you claim the deduction, know that you are likely increasing your chances of IRS audit and be prepared for a potential uphill battle. This one is probably a close second on the categories that are challenged by the IRS as meals, entertainment, and travel (MET) deductions are one of the most frequently used and abused deductions. As such, high MET deductions, especially when not supported by substantial business revenue to justify the expense, will likely increase your risk of an IRS audit. This is not a huge red flag for everyone. As you get older in age, the IRS likely becomes more tolerant of medical expense deductions and, therefore, would be less likely to select you for examination based on this category alone. However, medical expenses are frequently abused by some on the form or another by taxpayers trying to write off cosmetic and other aesthetic procedures as legitimate medical expenses. In addition, medical travel has been a huge potential area for abuse as some taxpayers game the system to try and absorb some of their personal travel costs. One of the biggest telltale signals of potential abuse is when medical expenses (or Schedule A expenses in general) rise as income rises or there is significant medical expense for someone who is younger and does not have a history of high medical expense deductions. Again, many taxpayers are entitled to and legitimately have high medical expenses. However, like most other Schedule A deductions, there is often great potential for abuse. Rental property has been a particular subject for abuse in recent years with the dramatic changes in the housing market. As such, many people have been unscrupulously padding losses into their investment properties to help offset income from other sources. This happens frequently with those who have portfolios with multiple properties and who may be unfairly using losses to offset large gains. In some cases, these losses can be fairly substantial and result in a significant tax loss to the government. Rental property losses in the first year or even the first few years will not necessarily trigger an audit, particularly because of the illiquidity in the housing market, but sustained losses draw scrutiny from the IRS. Think of it this way – why would someone continue to dump money into a losing investment year after year for a purpose other than to generate a tax loss (i.e. no significant business reason)? Also, abnormal losses for a certain year may also raise a red flag particularly with frequently abused/misreported expense categories such as repairs and maintenance (the IRS will audit you for capital expenditure treatment).18. Home Office Deductions
19. Claim Business Meals, Entertainment and Travel Expenses
20. Medical Expenses
21. Losses from Rental Property
22. Margin percentages
Tax returns are a treasure trove of information, and the IRS has become increasingly sophisticated at utilizing this information to make itself more effective. This is not just limited to individual taxpayers, but also groups of taxpayers who live in the same area or who have similar jobs in similar industries.
It collects enough statistical data to come up with median figures or ranges of where it expects taxpayers to be in certain categories and audits those who are outliers.
For example, let’s say the median income for a household in Beverly Hills, California was $200,000 per resident. If you are a taxpayer that filed a tax return claiming only $50,000 in income, it would be safe to assume that you might attract the attention of the IRS.
Similarly, a taxpayer who made tens of thousands more than the median income in a given area would also likely arouse suspicion within the IRS. The same reasoning also holds true with taxpayers in similar industries.
Plumbers making hundreds of thousands of dollars or CEOs pulling in just over minimum wage will also likely be subject to audit. Certain professions also carry higher audit risk than others.
Audit Technique Guides published by the IRS can also provide some clues as to what the IRS views at professions with a higher proclivity for abuse.
The IRS also uses statistics to look for likely IRS audit red flags with businesses by comparing their margins. As an attorney, one of the first things that I look for when a small business owner approaches me about representing their business in an audit is what their margin percentages are.
Gross Margin Percentage = (Revenue – Cost of Goods Sold) / Revenue
Net Margin Percentage = Net Profit / Revenue
There is not a magic number for what your margins need to be. Every business is run differently and will have different margin percentages based on their annual revenue and their expenses.
However, even though businesses will all vary on their margin percentages, margin percentages for a particular sector among similar businesses will largely be within a certain range.
The IRS knows this and IRS audit red flags may be raised for businesses that are outliers, either with margins that are too low or too high. For your own edifice on what traditional margins are for your industry, there are many sources online that will tell you.
Let me show you how margins can work against you on your tax return. Say I own Convenience Store A. I file a tax return indicating that I made a 10% percent profit from the store after my expenses. No problem there. Now let’s say that Convenience Stores B, C, D, E, F, and G all file tax returns showing a 30-35% profit. That is quite a step up from 10% profit.
There are several possible explanations here. I could be a bad businessperson. My revenue might be the same as these stores, but perhaps I am not keeping my expenses or my cost of goods sold in check.
Consequently, I could have the same expenses and show less revenue because of a loss of business. Both of those are perfectly logical explanations. However, if I am not keeping up with my competitors, I am likely not going to stay in business for very long.
I could also be skimming cash from the registers and underreporting income (decreasing my revenue) or inflating my cost of goods sold (reducing taxable profit) or inflating my operating expenses (also reducing taxable profit).
In contrast, if I start showing 75% profit, I am either the world’s greatest convenience store operator or there is a serious impropriety with my business.
My point is that you operate in the audit danger zone if you are outside the generally accepted range for businesses that are similar to yours. Tax cheaters will often try and bury deductions into other expense categories to not make them stand out or will make sure there is no paper record of them taking money out of the cash register.
However, if they go too far outside the lines, it is probable that they will raise some IRS audit red flags and their margins that will eventually catch up to them.
23. Small Business Schedule C Losses
Many of my frustrated, wage earning, tax preparation clients ask me all the time if they can lower their tax liability by starting a “business” and deducting their expenses. I caution against this idea for several reasons.
For starters, most taxpayers fail to consider the material participation requirement when launching their new business. As such, they deduct income that should be characterized as a passive loss against active income – a schedule c red flag – and get nailed by the IRS in an audit.
Think about it: How many people do you know with full time jobs that spend 750 hours or more in another business? Probably not too many.
In addition, side businesses that show losses in multiple years are subject to review for actual profit motivation under the hobby loss rules, which is a schedule C red flag that the IRS can and does audit regularly.
Just because you love making arts and crafts projects in the garage or enjoy racing cars on the weekend does not mean that you are engaging in these activities with the motivation of making a profit.
The IRS knows this and your DIF score may increase, especially with a side business with an element of fun in them (travel writer, beer/wine making, horse racing, any sort of professional gambling, etc…).
The IRS has been onto this trick for several years now and will audit businesses that show losses or that have the appearance of trying to off-set legitimate tax liability.
24. Mileage and Vehicle Expenses
If I could pick one area where my clients frequently fail to provide proper substantiation, it would be business miles. Revenue agents (and the code) require documentation in the form of a mileage log, but I have known very few people who actually log mileage.
The worst part is because so few taxpayers keep proper mileage documentation then they usually estimate this category by using (you guessed it) numbers that end in a few zeros. The IRS has been onto mileage for years and it is one of the areas I see targeted most in an audit.
Major vehicle expenses (absent a profession that requires frequent travel) are a big target for the IRS.
However, the good news is that is where the bad news stops.
Revenue agents will use the internet to confirm business locations, but other than a few isolated instances I have not seen too many challenge your expenses much further.
25. Frequent Stock Trades
Frequent stock trading has a very high margin of reporting error and might earn you a review of your tax return by the IRS.
There is nothing wrong with frequent trading and a good tax preparer can actually make the reporting pretty straight forward (many brokerages have gotten a lot better with the information contained in their statements.
However, because of the complexity that occurs from some transactions or the difficulty in properly calculating basis for stock trades (and therefore appropriate gain and loss), the IRS sometimes will want to take a second look at your return to make sure this has been done accurately.
However, these issues are often time consuming and difficult, so I personally have not seen too many returns subjected to an IRS audit on the basis of stock trading alone unless there is a mistake on the return.
A word to the wise for traders though. I hope that if you are dealing in frequent trades or asset sales that you have a tax attorney, CPA, or someone else knowledgeable enough to prepare your returns.
Although mistakes can and do happen, they are significantly reduced when you hire a preparer comparable to the level of sophistication of the tax return. In most cases, if you follow this rule, you should be fine.
However, make sure (especially in this instance) to save all documentation relating to any stock trades or the sales of that asset – especially how you valued it. This will make or break you should you have to undergo an IRS audit.
How can I stop these IRS audit risk factors affecting me?
So, how does this all relate to your own tax audit risk and how to avoid the risk of audit? Simple. When preparing your return this year, start with asking yourself this question: DOES MY TAX RETURN MAKE SENSE? Followed by:
Is all my income accounted for and reported correctly?
Do the deductions listed on my Schedule A (where you itemize) make sense?
Do I have excessive charitable contributions for someone of my income level (especially in comparison to the past three years)?
Do my business expenses make sense (are you a plumber that wrote off international travel)?
Are said expenses likely to be considered ordinary and necessary by the IRS?
Do you see where I am going with this? When clients use our tax representation services, most of the red flags for tax returns that come across my desk which have been selected by the IRS for an audit may include some questions that I cannot answer off the bat.
If your return comes across my desk and I am left asking questions, then that’s probably the reason your return was selected for an IRS audit – i.e., the manual reviewer had those same questions and stuck it with a red flag for tax audit.
What story did your tax return tell the IRS? Did it furiously waving some IRS audit flags you might be now be worried about, or have you already been notified of an audit?
Call Brotman Law and we’ll set up a tax action plan. Whether it’s crypto transactions, you own a cash intensive business, or have a bank account in Mexico, a professional tax audit lawyer from our company can clean up your tax liabilities today and advise you how to optimize your tax filing in the years to come.
Key takeaways on IRS tax audit red flags
So let’s review how IRS red flag auditing works. All tax returns are processed into a computer, where they are assigned two scores:
a DIF score (assessing the potential changes on a tax return [i.e. increased revenue]) and
a UDIF score (assessing the potential that there is unreported income on a tax return).
Returns with high scores are sent to an IRS reviewer, who manually examines a return to determine its potential for audit.
Those that are selected by the reviewer are sent to local field offices where a revenue agent will conduct an IRS audit.
Those not selected by the reviewer are tossed back into the pile and are safe from audit.
The IRS only conducts a certain amount of IRS audits every year. Because of this, it selects the tax returns that are most likely to yield revenue or that contain the greatest potential for error for additional review. These are also the same tax returns that tend to contain IRS audit penalties.
Think of it from the government’s perspective: why would they devote manpower, time, and limited resources toward auditing a return that is likely not going to yield them additional revenue? Answer – they probably won’t.
FAQs on the red flags for IRS audits
Does the IRS audit everyone?
It may be a relief to know that the IRS does not have the resources to audit everyone’s return. It sets priorities based on certain factors reported in the return and the person who filed it. This is how they try to find potential tax revenue not reported.
Who does the IRS audit the most?
According to a 2021 article in the Wall Street Journal, “Fewer than one million Americans get audited each year. But individuals who don’t file their taxes, or underreport their income, are top of the list.” Taxpayers who have recently made cryptocurrency or NFT transactions are also frequently audited.
Do all taxpayers have an equal probability of having their tax returns audited?
No. The IRS 2017 audit rates determined the average individual audit rate of 1040 taxpayers was 1 out of 161. International taxpayers had the highest probability (1 out of 19). People who made $200,000 or less and didn’t claim the EITC were the least likely (1 in 364).
What are the most common self-employed audit red flags?
Too many deductions taken are the most common self-employed audit red flags. The IRS will examine whether you are running a legitimate business and making a profit or just making a bit of money from your hobby. Be sure to keep receipts and document all expenses as it can make things a bit ore awkward if you don't. Here's some more information on what happens if you get audited and don't have receipts so you can get an idea of the trouble it causes.
What are the most common IRS red flags for small business owners?
Owning a small business such as auto dealership, a restaurant, a beauty salon, a car service or cannabis dispensary is an IRS red flag, as they typically have many cash transactions. Red flags are also raised on outliers – businesses with margins that are too low or too high.
