It’s that time in April when all of our palms start to get sweaty—tax season. Taxes bring with them a variety of stresses, one of which produces a question that unfortunately doesn’t end when you file your taxes—what if I get audited? Risk of audit can last for 6 years, but experts say if an audit is going to happen, it will likely take place 2-3 years from the date you filed.
But there’s good news when it comes to audits! Audit risk is the lowest it’s been in nearly 15 years. In 2016, the IRS audited only .7% of individual tax returns. That’s a mere 7 audits for every 1,000 returns filed. Many can rest in those statistics, but there are certain things to be cognizant of that will put you at higher risk. Below are 5 audit “red flags” to be aware of:
- High Income: No surprise here. With a tightening budget, the IRS wants to spend time where it pays the most. If your income is above $200,000, your audit risk is just under 2%--still not bad. But, if your income is $1 million or more, your risk jumps to 5.83%.
- Income Discrepancies: If you report lower income than is reported to the IRS by your employer(s), investment custodians, or even a casino following gambling winnings, your audit risk increases. The bottom line here is to carefully match the income you’re reporting with the tax documents you receive. With electronic delivery, some income statements (1099s from investment income, for example) may be easily missed as they’re posted to your online account rather than emailed. Comparing to your previous year’s return (which most software systems do automatically) can be a good check/balance. But, be sure to note in your tax file throughout the year if you open a new account during the year, or have a new source of income.
- “Abnormal” Deduction Amounts: The IRS tracks average deductions by income level—interest expense, charitable contributions, etc. If your deductions are outside the range of the average household in your income level, your risk increases. Thus, if you’re especially charitably inclined or if you pay a lot in real estate taxes, your risk of audit rises. A recent Forbes article delved into these averages. The article notes a slew of income averages, but for illustrative purposes we’ll look at one. If your income level is about $200,000 and you contribute more than $5,600 to charity, you’re considered outside the “normal” range.
- Being self-employed: This is largely in part due to filing complexities. Additionally, income tax payments are the sole responsibility of the self-employed individual. Errors are more likely when there is not an employer tracking and reporting income/withholding . . . and there are more ways to cheat if you choose to. If you’re self-employed and like to push the tax limits, carefully weigh the benefit with the headache of a potential audit.
- Home Office Deductions: While this can be a helpful deduction for those qualifying, it may not be worth the audit risk. If you also have wages reported from an employer, this can draw the IRS's attention, as the IRS thinks it’s less likely you truly have a qualifying home office. These rules are easily misunderstood, so if you claim this deduction, make sure you’re doing so accurately.
- Other Risks: Real estate losses, early payouts from IRAs and 401(k)s, and reporting losses from activities that may be deemed hobbies are other common audit risks.
The take-home points are to: A) keep good records and B) if you feel you’re at a higher risk of an audit, consider enlisting a tax expert who can confirm you’re filing accurately and who will interface with the IRS on your behalf should an audit arise.
A review of our clients’ tax situation, provided by Doug Yoakley, is included in our financial planning engagements. If you would like to learn more about our financial planning services, please visit pyawaltman.com or contact Melissa Ballard at 865.693.6301 or [email protected].