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Jewish World Review 14 IRS Audit Red Flags By Joy Taylor JewishWorldReview.com | Short on personnel and funding, the IRS audits less than 1% of all individual tax returns annually. We expect the audit rate to fall even lower as resources continue to shrink and even more employees are reassigned to identity theft cases. So the odds are pretty low that your return will be picked for review. And, of course, the only reason filers should worry about an audit is if they are fudging on their taxes. That said, your chances of being audited or otherwise hearing from the IRS increase with key factors, including your income level, the types of deductions or losses you claim, how you make your money and whether you own foreign assets. Math errors may draw IRS inquiry, but "they'll rarly lead to a full-blown exam. Although there's no sure way to avoid an IRS audit, these 14 red flags could increase your chances of unwanted attention from the IRS. MAKING TOO MUCH MONEY Although the overall individual audit rate is only about one in 100, the odds increase dramatically as your income goes up. Recent IRS statistics show that people with incomes of $200,000 or higher had an audit rate of 3.70%, or one out of every 27 returns. Report $1 million or more of income? There's a one-in-eight chance your return will be audited. We're not saying you should try to make less money--everyone wants to be a millionaire. Just understand that the more income shown on your return, the more likely it is that you'll be hearing from the IRS. FAILING TO REPORT ALL TAXABLE INCOME The IRS gets copies of all 1099s and W-2s you receive, so make sure you this income. IRS computers are pretty good at matching the numbers on the forms with the income shown on your return. A mismatch sends up a red flag and causes the IRS computers to spit out a bill. If you receive a 1099 showing income that isn't yours or listing incorrect income, get the issuer to file a correct form with the IRS. Taking Large Charitable Deductions We all know that charitable contributions are a great write-off and help you feel all warm and fuzzy inside. However, if your charitable deductions are disproportionately large compared with your income, it raises a red flag. That's because the IRS knows what the average charitable donation is for folks at your income level. Also, if you don't get an appraisal for donations of valuable property, or if you fail to file Form 8283 for donations over $500, you become an even bigger audit target. And if you've donated a conservation or façade easement to a charity, chances are good that you'll hear from the IRS. Be sure to properly document everything. CLAIMING DAY-TRADING LOSSES ON SCHEDULE C Those who trade in stocks and securities have significant tax advantages compared with investors. The expenses of traders are fully deductible and traders' profits are exempt from self-employment tax. Losses of traders who make a special section 475(f) election are fully deductible and aren't subject to the $3,000 cap on capital losses. And there are other tax benefits. But to qualify as a trader, you must buy and sell securities frequently and look to make money on short-term swings in prices. And the trading activities must be continuous. The IRS knows that many filers who report trading losses or expenses on Schedule C are actually investors, who profit mainly on long-term appreciation and dividends, hold their securities for longer periods and sell much less often than traders, and can only report their expenses as a miscellaneous itemized deduction on Schedule A, subject to an offset of 2% of adjusted gross income. So it's pulling returns and checking to see that the taxpayer meets all of the rules to qualify as a bona fide trader. FREE SUBSCRIPTION TO INFLUENTIAL NEWSLETTER Every weekday JewishWorldReview.com publishes what many in the media and Washington consider "must-reading". HUNDREDS of columnists and cartoonists regularly appear. Sign up for the daily update. It's free. Just click here. CLAIMING RENTAL LOSSES The IRS is actively scrutinizing rental real estate losses, especially those written off by taxpayers claiming to be real estate pros and whose W-2 forms or other businesses show lots of income. Agents are checking to see whether these filers worked the necessary hours, especially in cases of landlords whose day jobs are not in the real estate business. The IRS started its real estate professional audit project several years ago, and this successful program continues to bear fruit. The rules require you to spend more than 50% of their working hours and 750 or more hours each year materially participating in real estate as developers, brokers, landlords or the like to write off losses without limitation. Also, if you actively participate in the renting of your own property, you can deduct up to $25,000 of loss against your other income. But this $25,000 allowance phases out as adjusted gross income exceeds $100,000 and disappears entirely once your AGI reaches $150,000. DEDUCTING BUSINESS MEALS, TRAVEL AND ENTERTAINMENT Schedule C is a treasure trove of tax deductions for self-employeds. But it's also a gold mine for IRS agents, who know from experience that self-employeds sometimes claim excessive deductions. History shows that most underreporting of income and overstating of deductions are done by those who are self-employed. And the IRS looks at both higher-grossing sole proprietorships and smaller ones. Big deductions for meals, travel and entertainment are always ripe for audit. A large write-off here will set off alarm bells, especially if the amount seems too high for the business. Agents are on the lookout for personal meals or claims that don't satisfy the strict substantiation rules. To qualify for meal or entertainment deductions, you must keep detailed records that document for each expense the amount, the place, the people attending, the business purpose and the nature of the discussion or meeting. Also, you must keep receipts for expenditures over $75 or for any expense for lodging while traveling away from home. Without proper documentation, your deduction is toast. CLAIMING 100% BUSINESS USE OF A VEHICLE When you depreciate a car, you have to list on Form 4562 what percentage of its use during the year was for business. Claiming 100% business use of an automobile is red meat for IRS agents. IRS agents are trained to focus on this issue and will scrutinize your records. Make sure you keep detailed mileage logs and precise calendar entries for the purpose of every road trip. Sloppy recordkeeping makes it easy for the revenue agent to disallow your deduction. As a reminder, if you use the IRS' standard mileage rate, you can't also claim actual expenses for maintenance, insurance and other out-of-pocket costs. The IRS has seen such shenanigans and is on the lookout for more. WRITING OFF A LOSS FOR A HOBBY ACTIVITY You must report any income you earn from a hobby, and you can deduct expenses up to the level of that income. But the law bans writing off losses from a hobby. For you to claim a loss, your activity must be entered into and conducted with the reasonable expectation of making a profit. If your activity generates profit three out of every five years (or two out of seven years for horse breeding), the law presumes that you're in business to make a profit, unless the IRS establishes otherwise. So make sure you run your activity in a businesslike manner and can provide supporting documents for all expenses. CLAIMING THE HOME OFFICE DEDUCTION Like Willie Sutton robbing banks (because that's where the money is), the IRS is drawn to returns that claim home office write-offs because it has found great success knocking down the deduction and driving up the amount of tax collected for the government. If you qualify, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance and other costs that are properly allocated to the home office. That's a great deal. And beginning with 2013 returns, you have a simplified option for claiming this deduction. The write-off can be based on a standard rate of $5 per square foot of space used for business, with a maximum deduction of $1,500. To take advantage of this tax benefit, you must use the space exclusively and regularly as your principal place of business. "Exclusive use" means that a specific area of the home is used only for trade or business, not also for the family to watch TV at night, or as a guest bedroom or children's playroom. Don't be afraid to take the home office deduction if you're entitled to it. Risk of audit should not keep you from taking legitimate deductions. If you have it and can prove it, then use it. TAKING AN ALIMONY DEDUCTION Alimony paid by cash or check is deductible to the payer and taxable to the recipient, provided certain requirements are met. For instance, the payments must be made under a divorce or separate maintenance decree or written separation agreement. The instrument can't say the payment isn't alimony. And the payer's liability for the payments must end when the former spouse dies. You'd be surprised how many divorce decrees run afoul of this rule. The rules on deducting alimony are complicated, and the IRS knows that some filers who claim this write-off don't always satisfy the requirements. It also wants to make sure that both the payer and the recipient properly reported alimony on their respective returns. A mismatch in reporting by ex-spouses will almost certainly trigger an audit. Alimony doesn't include child support or noncash property settlements. RUNNING A SMALL BUSINESS Small business owners in cash-intensive businesses--think taxis, car washes, bars, hair salons, restaurants and the like--are a tempting target for IRS auditors. Experience shows that those who receive primarily cash are less likely to accurately report all of their taxable income. The IRS has a guide for agents to use when auditing cash-intensive businesses, telling how to interview owners and noting various indicators of unreported income. Other small businesses will also face extra audit heat, as the IRS shifts its focus away from auditing regular corporations. The agency thinks it can get more bang for its audit buck by examining S corporations, partnerships, limited liability companies and sole proprietorships. So it's spending more resources on training examiners about issues commonly encountered with pass-through firms. FAILING TO REPORT A FOREIGN BANK ACCOUNT The IRS is intensely interested in people with money stashed outside the U.S., especially those in tax havens, and tax authorities have had success getting foreign banks to disclose account information. The IRS has also used voluntary compliance programs to encourage folks with undisclosed foreign accounts to come clean--in exchange for reduced penalties. The IRS has learned a lot from these amnesty programs and has been collecting a boatload of money (we're talking billions of dollars). It's scrutinizing information from amnesty seekers and is targeting the banks that they used to get names of even more U.S. owners of foreign accounts. Failure to report a foreign bank account can lead to severe penalties. Make sure that if you have any such accounts, you properly report them. This means electronically filing FinCEN Form 114 by June 30 to report foreign accounts that total more than $10,000 at any time during the previous year. And those with a lot more financial assets abroad may also have to attach IRS Form 8938 to their timely filed tax returns. ENGAGING IN CURRENCY TRANSACTIONS The IRS gets many reports of cash transactions in excess of $10,000 involving banks, casinos, car dealers and other businesses, plus suspicious-activity reports from banks and disclosures of foreign accounts So if you make large cash purchases or deposits, be prepared for IRS scrutiny. Also, be aware that banks and other institutions file reports on suspicious activities that appear to avoid the currency transaction rules (such as persons depositing $9,500 in cash one day and an additional $9,500 in cash two days later). If deductions on your return are disproportionately large compared with your income, the IRS may pull your return for review. But if you have the proper documentation for your deduction, don't be afraid to claim it. There's no reason to ever pay the IRS more tax than you actually owe. TAKING HIGHER-THAN-AVERAGE DEDUCTIONS If deductions on your return are disproportionately large compared with your income, the IRS may pull your return for review. But if you have the proper documentation for your deduction, don't be afraid to claim it. There's no reason to ever pay the IRS more tax than you actually owe. Sign up for the daily JWR update. It's free. Just click here. Interested in a private Judaic studies instructor — for free? Let us know by clicking here. Comment by clicking here. Joy Taylor is Assistant Editor o The Kiplinger Tax Letter. All contents copyright 2013 The Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC