Are there strategies to avoid an IRS audit? What are some of the known risks for triggering an IRS audit? What should you do if you have are concerned about the information provided a previous tax return? Is there a way to amend a previous return or come into compliance with IRS and US Treasury reporting requirements without attracting the attention of auditors?
Simple, Obvious and Straightforward
The most common strategies to avoid an IRS audit involve accuracy and honesty. The IRS has developed automated systems to look for inaccuracies as well as information the IRS is aware of that has not been disclosed by the US taxpayer. The most simple, obvious and straightforward strategy to avoid an IRS audit is to file all returns on time and provide accurate, truthful and well documented information regarding all sources of income, as well as the tax credits and deductions claimed within the return.
Accuracy and E-Filing
Make sure all entries in the return are accurate and double check your math prior to entering any piece of information as well as how that information relates to other elements within your return. Most US taxpayers use some form of tax preparation software so there is less chance for mathematical error. This also makes it easy to e-file a US tax return.
The vast majority of tax returns in the United States are e-filed (through external providers or your tax software). The act of e-filing alone can help to prevent errors and mistakes and lower the risk of an IRS audit. The IRS reports the error rate for a paper return is just above 20%, while the error rate for an electronic return submission is less than 1%.
The Impact of FATCA – The IRS Knows More About You than You Might Think
If your goal is to avoid an audit it is best to presume the IRS already has most if not all of the information you are providing within a tax return. The global impact and adoption of the Foreign Account Tax Compliance Act or FATCA has changed information gathering and reporting around the world. The IRS receives direct information regarding the holdings and transactions of US taxpayers from financial institutions and sovereign tax authorities around the world.
The IRS has invested heavily in upgrading their data processing systems and analysis software (including the deployment of Artificial Intelligence applications). These advanced systems make it much easier for the IRS to apply the information provided in a return to the numbers and information they have received from employers, 1099s, business returns and banking/investment institutions here in the US and worldwide. The information reported by the US taxpayer must not only add up with the return, but match the information received directly by the IRS from external sources.
Proven Strategies to Avoid an IRS Audit: Avoid Known Audit Triggers (Red Flags)
Proven strategies to avoid an IRS audit begin with an informed understanding of the types of targets the IRS has elected to pursue, known as “red flags.” There are several known red flags that could trigger an IRS audit – especially for those with incomes above $250,000. The IRS publishes it’s own “dirty dozen” tax scam warning list and several notices a year to provide insight into red flags and potential audit targets.
Of course, you always want to make sure that the income you report matches all W-2 and Form 1099 income that will be reported by others to the IRS. Perhaps the most commonly known and discussed audit trigger is unusually high itemized deductions (such as charitable contributions), losses or tax credits that exceed the IRS’ average for your income range.
The IRS creates a “bell curve” for every element of a business or personal tax return that determines statistical averages for each element based upon taxpayer income. Those returns that fall outside of the “reasonable” limits established within the bell curve can bring a return to the attention of the IRS. For example, if a taxpayer claims a much higher level of itemized deductions in general for their range of income, or a specific type of deduction such as charitable contributions the return may be flagged for review and/or audit.
Business Expenses and Losses
Returns exceeding $250,000 with losses reported on a Schedule C (Profit or Loss From Business) are highly scrutinized. For example, claiming that a personally owned vehicle is used 100% for business is known to be a primary red flag. The agent will look at mileage logs and even calendar entries and supporting correspondence and communications to verify the nature of each “trip.” The IRS knows from years of audit results that filers who are claiming 100% business use for a vehicle are more likely to report other unreasonable or undocumented claims and inconsistencies.
Losses on Schedule C must be thoroughly documented. Heavy Schedule C losses for multiple years is another easy red flag for the IRS, especially if these losses relate to real estate or activities which the IRS could assert to be a “hobby” and not a “business.”
Business owners must be cautious about the percentage of home mortgage and expenses that are allocated for a home office, and you should document these calculations for the IRS. Those with an S Corporation should make sure that the owner’s salary is not conspicuously low. Taking a low salary and then distributing profits that result in a high income (six figures) may be a huge audit flag to the IRS. Large amounts for meals and entertainment expenses for any type of business are often cited as audit targets.
Offshore Income, Business, Investments and Assets
Offshore financial activities require sophisticated strategies to avoid an IRS audit and extensive legal and financial exposure. Offshore income, business activities, investments and assets continue to be a major audit focus for the IRS. All US taxpayers are required to file a Report of Foreign Bank and Financial Accounts or FBAR, also known as FinCEN Form 114 if the total or aggregate value of offshore financial accounts for a US Taxpayer exceeds $10,000 at any point during the calendar tax year. This isn’t $10,000 per account, it is the total of all accounts. If the aggregated total exceeds $10,000, even for a single day, the US taxpayer is required to disclose all offshore financial accounts through electronic filing of the FBAR.
The IRS receives direct electronic reporting of account and transaction information for US taxpayers from banks, investment houses and even cryptocurrency exchanges around the world. The IRS then simply has to compare this information with the data disclosed by a US taxpayer on their tax return. Failure to disclose offshore income and assets can result in substantial financial penalties, as well as civil and potentially criminal exposure relating to tax fraud.
The issues associated with foreign bank accounts, assets, real estate, investments including retirement vehicles, foreign corporate ownership and trusts are too vast and complex to discuss in this space. If you have offshore income, losses, assets or accounts you have a substantially increased risk for an IRS audit and need to seek the advice and counsel of an experienced international tax attorney or certified tax professional.
Cryptocurrency and Non-Fungible Tokens or NFTs
The IRS has made it clear that US taxpayers who hold, sell, mine, receive, trade or even transfer cryptocurrency assets (virtual currencies) or NFTs are a primary audit target. Many cryptocurrency investors are not aware that simply transferring crypto assets from one wallet or exchange to another creates a taxable event, even if the transfer value is the same on both sides of the transaction.
US taxpayers are asked a question at the top of the IRS Form 1040: “At any time during (given tax year) did you: (a) receive (as a reward, award or payment for property or services); or (b) sell, exchange, gift of otherwise dispose of a digital asset (or a financial interest in a digital asset)?”
Unfortunately, many US taxpayers with onshore and offshore cryptocurrency and NFT assets have answered “no” to this question. One must take note of the words in the “Sign Here” section of the 1040, just above the signature line:
“Under penalties of perjury, I declare that I have examined a copy of my individual income tax return and accompanying schedules and statements for the tax year ending December 31, (tax year), and to the best of my knowledge and belief, it is true, correct, and complete.”
Other Current IRS Audit Targets
Those with retirement accounts such as a 401(k) or IRA should discuss any early withdrawal (before age 59.5) with a tax professional. The IRS is watching these activities closely. It is important to note there are many legitimate reasons which avoid the early withdrawal penalties such as expenses related to disability or a substantial health event.
Non-filers are a primary target for the IRS. Those who under-report income by more than 25% and those who fail to file a return are primary targets of the IRS. The IRS has announced it is targeting those who have received unreported income (here in the US or abroad) exceeding $100,000.
Contact an Experienced San Diego Tax Attorney for Domestic or International Tax Questions and Issues and Transactional Planning
If you are concerned about proven strategies to avoid an IRS audit you probably have substantial income, a business, significant assets and/or international interests. You need an experienced, proven San Diego tax attorney who can answer your domestic and international tax questions while working with you to develop and implement transactional planning to protect assets and reduce or eliminate risk while minimizing the impact of taxation upon your earnings.
If you are concerned about inaccuracies or issues associated with correcting a previous return in order to come into compliance with the IRS and reduce the likelihood of an IRS audit we invite you to learn more about the integrated tax, legal, accounting and business consulting services of Allen Barron and contact us or call today to schedule a free consultation at 866-631-3470.
