No one wants to see an Internal Revenue Service (IRS) audit letter in the mail — or in the worst case, an auditor show up at his or her door. The IRS can’t audit every American’s tax return, so it relies on guidelines to select the ones most deserving of its attention.
Here are six flags that may make your tax return a prime for an IRS audit.
The Chance of an Audit Rises with Income
According to the IRS, only about 1% of all individual taxpayer returns are audited. However, the percent of audits rises to over 4% for those with incomes between $500,000 and $1 million and is over 4% for those making between $1 million and $5 million.
Deviations from the Mean
The IRS has a scoring system it calls the Discriminant Information Function that is based on the deduction, credit and exemption norms for taxpayers in each of the income brackets. The IRS does not disclose its formula for identifying aberrations that trigger an audit, but it helps if your return is within the range of others of similar income.
When a Business is Really a Hobby
Taxpayers who repeatedly report business losses increase their audit risk. In order for the IRS not to consider your business as a hobby, it generally needs to have earned a profit in three of the last five years. (Note, as of 2018, the rules have changed. Hobby losses can only be deducted to the extent of the related income.)
Non-Reporting of Income
The IRS receives income information from employers and financial institutions. Individuals who overlook reported income are easily identified and may provoke greater scrutiny.
Discrepancies Between Exes
When divorced spouses prepare individual tax returns, the IRS compares the separate submissions to identify instances where alimony payments may be deducted on one return, while alimony income goes unreported on the other party’s return. Another common tripwire is when both former spouses claim the same tax breaks for their children.
Claiming Rental Losses
Passive loss rules prevent deductions of losses on rental real estate, except in the event when an individual is actively participating in the property management (deduction is limited and phased out) or with real estate professionals who devote greater than 50% of their working hours to this activity. This is a deduction to which the IRS pays keen attention.