President Biden is seeking to bolster the IRS and enforcement of the tax laws over the next decade. In the last 10 years, the Internal Revenue Service’s funding has been cut by 20% causing the department to lose more than a fifth of its staff. With this lack of funding and staffing, the compliance department of the IRS has been inefficient and criticized for focusing attention on the wrong issues. These issues do not mean that compliance can be ignored. Keeping that in mind, here are 10 red flags that might draw attention to your return.
Not Reporting All Income
All income received, not just income reported on IRS forms, must be reported on your tax return. All tax forms that you receive, such as W-2 or 1099, are also sent to the IRS. They will cross-check to see if the recipient of the form reported it on their return. If it is not reported, it may trigger an “Automated Under Reporter” letter. This letter will notify you of the information omitted and the additional proposed amount of tax due.
Large Charitable Contributions
The IRS knows the average charitable contribution amounts for those at each income level. Very large charitable contributions, especially those disproportionate to your income, are a red flag. Make sure to keep all donation receipts and any supporting documentation. For large noncash donations be sure to meet the documentation requirements.
Having a Schedule C Business
High revenue and/or large losses are red flags for Schedule C filers. Businesses that have losses in 3 of the last 5 tax years are also at risk because it may be considered a hobby rather than a business. Cash intensive businesses like pawn shops, salons, or car washes are risky because they are more likely to have underreported receipts. A Schedule C with “excessive” meal expenses may be at risk of the IRS auditing for non-deductible entertainment. Claiming 100% business use of a vehicle is also a risk because it is unlikely there is no personal use of the vehicle, especially if there is no other vehicle available for personal use.
Rental Property Losses
The IRS tends to scrutinize returns with large, consecutive rental losses, particularly of those claiming to be real estate professionals this is supposed to be their main source of income. Taxpayers with passive rental properties (non-real estate professionals) may deduct up to $25,000 of real estate losses against other income if their income is below $150,000. Real estate professionals with non-passive rentals can deduct full rental losses.
Return Not Filed or Filed Late
As mentioned previously, the IRS receives copies of all forms that are given to a taxpayer. If you do not file a return, you will likely be sent a letter in the mail with the IRS’s calculation of what is owed, based on the forms they have on file. This is a big red flag, especially for those taxpayers with income over $100,000 and for tax preparers who do not file their own return.
Income over $1 Million
As mentioned above, more income means more scrutiny. The IRS audited a larger portion of tax returns that had an income of over $1 million. Be sure to maintain concrete evidence for all deductions that you take on your return.
Participating in Virtual Currency Transactions
This is still a relatively new area of investment and ecommerce and the IRS continues to create rules for those who participate in transactions. Generally, these transactions are treated as stock transactions if the taxpayer bought the currency as they would buy stock. However, depending on how the cryptocurrency is acquired (received as wages, in exchange for goods and services, or mined) and how it is used, it may be taxed differently. The crackdown on cryptocurrency stems from the IRS’s efforts to staunch streams of unreported income.
The IRS recently went to court with Coinbase, a virtual currency exchange, to acquire names and other information of their users. This is a continuing legal battle regarding whether the IRS overstepped its bounds and invaded the privacy of the platform’s users, with the potential to affect all cryptocurrency users.
Failing to Provide Foreign Account Information and Claiming the Foreign Earned Income Exclusion
Severe penalties can be levied on taxpayers who, intentionally or unintentionally, fail to report foreign account information. The IRS is concerned about taxpayers hiding money offshore, particularly those commonly known as tax havens with very low effective tax rates and share very little information with foreign tax authorities, i.e. the Cayman Islands, and other Caribbean Islands.
The foreign earned income exclusion allows US taxpayers to exclude up to $108,700 (2021 limit) of their income earned in another country. There are specific criteria to claim this exclusion and the IRS has turned its crosshairs on those claiming it, trying to sniff out those who do not meet the criteria. They focus on those taxpayers with no place of abode or nominal attachments to the foreign country, such as flight attendants/pilots, and US government employees who work overseas. US Government employees are not eligible to use the Foreign Earned Income Exclusion, but their spouses may be eligible.
Home Office Deductions
As with the foreign earned income exclusion, there are specific criteria for those wishing to claim home office deductions. To be eligible you must use a portion of your home exclusively for business on a regular basis, and not as an employee of another. It must be an area that is only used for business, like a home office. Setting up in your family dining room is not eligible. This deduction can be small, to upwards of a couple of thousand dollars, so the IRS will crack down on the deduction to make sure the requirements are met.
Alimony agreements in place prior to 2018 are included in the recipient’s income and deducted on the payer’s return. When reporting that information, the taxpayer inputs the tax ID number of the other party, and the IRS cross-checks the information. If the recipient does not include it in their income, they will likely receive a notice.
Taking all these things into consideration, you are still entitled to take all eligible credits and deductions. Just make sure that you retain the information used to support your decision to take them. This support might come in the form of receipts, canceled checks, banks statements or tracking of time spent on activities. Just because your tax return may have some of these items does not mean your return will be audited. However, compliance with the tax law cannot be ignored.
If you need help with any correspondence with a taxing authority or your return has become more complicated and we can be or assistance, please contact us.
Written by: Danielle Gollehon
Danielle Gollehon joined Thompson Greenspon as a Tax Staff Accountant in August 2019. She provides tax preparation and tax planning services for both individual and business clients throughout the year. She is working towards developing a tax specialization in construction.
Danielle attended The Ohio State University and graduated in August 2019 with a BSBA with a specialization in accounting. She is currently in the process of taking the CPA exam to become a Certified Public Accountant.
Danielle is a member of the American Institute of Certified Public Accountants and the Virginia Society of Certified Public Accountants.
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