If you are like so many other Americans you probably agree that there are few things in this world that are more inconvenient or scary than being audited by the IRS. The IRS flags a tiny fraction of tax returns every year, and half of those belong to people making over a million dollars per year. Still, just hearing the word audit is often enough to strike fear in the hearts of millions.
Fortunately for you, most audits do not end in huge fines or jail time; as long as you can provide the documentation to back up your figures, your audit will go off without a hitch. Problems only arise whenever they find evidence of illegal activity or there is a lack of records to support your claims. This is why organizing and holding on to your relevant records and statements is so important to stay out of trouble with the IRS. While your chances of being randomly selected for an IRS audit are amazingly small, there are a few things that you can avoid to keep the IRS off your back.
What Is A Tax Audit
We hear about audits all the time, but what does it even mean to be audited? Well, an audit is an examination of financial accounts. Your company may be audited by a parent company, or your department may be audited if you work directly with company finances. The IRS does not hold the monopoly on audits, but they do oversee the most important audits most of us will ever be a part of. When you receive a notice that you are being audited by the IRS, that means that a department of the federal government is investigating you and you company’s or individual’s accounts and financial information to ensure you are paying what you are supposed to pay and Uncle Sam gets his money.
Earning More Than A Million Dollars
That’s right. It pays to be poor. Well, maybe not poor, but if you earn an income under that 1 million mark, you are considerably less likely to be audited by the IRS than those that do. In 2019 the American audit rate was around 1% for your average teacher on the street, while the audit rate for those surpassing a million dollars went up to 2.4%.
This is because high incomes so often come with a higher chance of major tax mistakes or crimes that can cost the government millions. Higher income also typically comes with more exceptions and write-offs such as large charitable donations, major investments, secondary or income-producing real estate, and large cash purchases throughout the year that may trigger an audit.
Rounding Off Numbers
We have all been in a situation where we are filling out your tax return and the form asks us for a number that we don’t know off the top of our heads. So, what do you typically do in these scenarios? If you are like so many of us, you round to the nearest number that you are sure of. Maybe you even round it up or down in the IRS’s favor to avoid negative repercussions.
Of course, you know that is not the way you are supposed to fill out tax returns, but what harm can it really do? It’s not like you are concealing money from the IRS, after all. You just don’t know where the most recent report on that stock you bought is. We are here to tell you, just go find the report. Whatever figure you need, take a break from filling out your return to go find the exact number. While a few dollars here and there may not seem like much to you, having rounded out numbers on your tax returns may look suspicious to the IRS and trigger an audit.
Heavily Cash-Based Businesses
As we transition more and more toward fully digital banking and accounting, it becomes easier and easier to track where income and expenditures are coming from. This is why companies that report a large percentage of their income in cash transactions are more likely to be audited. Cash transactions are not as easily tracked and, therefore, make it easier to report false numbers. It is a common enough issue that the IRS is several times more likely to audit more cash-based businesses like restaurants, laundromats, and nail salons than other businesses.
If you do run a cash-based business, it is even more important that you keep detailed records of every transaction. Keeping an accountant on staff to maintain your book scan help save you a ton of time and stress at the end of the year if the type of business you run does trigger an IRS audit.
Being Self Employed
If you are self-employed, chances are you have been warned of the higher audit rates that come with the territory. This is because of how much easier it is for small business owners who report only to themselves to conceal income. This does not only apply to physical business owners, but to any individual who works for themselves, even independent contractors. Private real estate agents, free-lance workers, accountants, and so many other professions are all more likely to be audited by the IRS.
Claiming A Home Office
In this post-COVID world, more people than ever before work primarily from home and a home office. This has become an increasingly popular deduction to claim, despite the fact that many people claiming a home office do not actually qualify.
While the home office deduction can be a valuable break to help you cover the many costs that you likely shouldered yourself to set up and maintain an office in your house, most displaced workers who now work from home do not actually qualify. The home office deduction is meant exclusively for individuals who are self-employed or independent contractors.
There are also many criteria that your home office must meet to qualify. For example, while your office does not need to be in a separate room, it has to be in an area of your home where you do not do anything else.This means that it cannot be in your living room or bedroom. The space should also be your primary place of business. This means that this should be the place where you take meetings, greet clients, and do the majority of your tasking.
Because so many people claim this deduction without qualifying for it, the IRS is far more likely to audit anyone who claims a home office deduction. If you are properly using this deduction and qualify in every way, make sure that you are documenting every expense well and can back up each claim if you are selected for an audit.
Early Withdrawal From A Retirement Account
It is not uncommon for taxpayers to take out early withdrawals from retirement accounts for one reason or another. Retirement accounts are typically nontaxable and can be one way to liquify part of your investment portfolio without taking the hit on your taxes.
Unfortunately, there are actually only a handful of situations in which you can remove money from your retirement account and it remains nontaxable. Most notably, if you are over 59 ½ years old, you can take nontaxable money out of your retirement account. You can also take out a 401 (k) loan which will typically increase your contributions so that the loan will be paid back with your regular salary or you can make Roth contributions. Otherwise, not accounting for that money in your annual tax return can lead to a fine if this triggers an audit.
Major Changes In Income
Life happens and sometimes so does change. If you are a business owner and you are seeing much higher or lower profits this year than you did last year, make sure you are keeping up with all proper documentation in case the change in income triggers an IRS audit.
The IRS is always on the lookout for large changes in both income and expenses of all businesses because this can indicate illegal activity such as money laundering and trafficking rings. As long as all of your documentation is in order, though, you should be good to go.
Keeping Money In Foreign Accounts
Any taxpayer with a foreign bank account who has deposited more than $10,000 over the course of the tax year is obligated to report the account to the IRS. Doing so and keeping detailed records of deposits, withdrawals, interest rates, and other activity is vitally important. Not reporting these accounts in your regular tax return can result in huge fines and criminal charges in some cases.
Oftentimes, just having a foreign bank account is enough to raise the red flags of the IRS. This is why meticulous record-keeping is so important.
Crypto or e-Currency
As far as the IRS is concerned, cryptocurrencies are taxable just like any other investment. It is treated as an asset, similar to stocks and bonds and must be reported in the same way. If you sell cryptocurrency, you are obligated to claim it like you would any capital gain or loss.
It is important to note that many cryptocurrencies are exceptionally simple to track because of the digital footprint they leave. This makes it easier for both you and the IRS to keep up with what you should be reporting on your annual tax return.
Who To Call If You Are Being Audited
While nobody wants to receive the dreaded IRS audit letter, it doesn’t have to be an ordeal. Whether you are innocent or guilty, chances are you have never had to deal with a visit from the IRS. This can be a scary meeting if you go in alone.
It is always in your best interest to get professional assistance when dealing with this type of problem. Even if you know that you have done nothing wrong, never meet with the IRS alone. Small mistakes can be used against you and you could end up paying fines that you could have avoided. If you do have a skilled attorney helping you, it will communicate to the IRS that you are taking it seriously, and that they will have to be at their very best to try and prove the case against you.