IRS Red Flags

Many times I am asked whether claiming a certain deduction will represent a “red flag” to the IRS and place my client under greater scrutiny from the IRS.  Although I disagree with several of the “red flag” rumors that are spread out there, some of them are legitimate and something to consider when deciding how aggressive you will be when submitting your tax return to the IRS and state agencies.  I thought it would be useful to discuss a few of these this month.  By the way, congratulations to those whose 2013 tax returns are completed and good luck to those who successfully requested an extension of time to file their 2013 tax returns.  We have a number of 2013 returns that we will yet complete before the business and personal extended due dates in September and October due to certain items of missing information related to those returns.

Generally speaking, as your income rises your chances of being audited, or at least questioned on certain deductions, increases.  This is because the IRS and state agencies know from experience that if they can find an error on the return of high income individual, the additional tax, penalties and interest they will garner will be much greater and more worth their while to come after.  This is because the tax rates involved are higher on these returns.  The statistic that I recently read was that roughly 1% of all tax returns are randomly selected for audit, while those tax returns with incomes of $200K or higher had an audit rate of 3.26%.  Additionally, for returns showing $1 million or more in income, the audit rate is more than 11%.

If deductions claimed on your return are disproportionately large compared to your income, the IRS is more likely to pull your return for review.  Having said that, if you have adequate documentation for your deductions, don’t hesitate to claim the deductions on your return.

If you hold large amounts of money in accounts outside the United States, the IRS takes great interest in this.  Because of the history of so many off-shore accounts being tied to illegal or tax avoidance schemes, the IRS is much more likely to examine the activity of such accounts.  In fact, for those with foreign accounts having balances over $10K, the taxpayer is required to disclose these to the IRS annually using a form separate from their standard income tax return.

Large deductions for meals and entertainment expense will often attract the scrutiny of the IRS as this is an area that is often abused by taxpayers.  In order to be deductible, expenses related to meals and entertainment must have a verifiable business purpose and usually must include clients, potential clients, associates, etc. and must not be excessive.  Without substantial documentation of who was taken to each game (professional sports season tickets) and what business was discussed, I have seen deductions for season ticket purchases reduced or eliminated under examination by the IRS.  Even after all hurdles are cleared to be legitimate, business deductions for meals and entertainment are generally only 50% deductible for tax purposes.  Travel expenses, on the other hand, are usually always fully deductible.

Schedule C business activity is an area that the IRS looks at closely, especially if you report large losses or consistent losses from year to year.  Historically, schedule C has been an area where taxpayers have often exaggerated expenses or under-reported revenue in order to save on their tax liability.  As such, the IRS keeps a watchful eye on schedule C activity.  Again, having said that, please don’t hesitate to claim legitimate business expenses here if you have sufficient documentation.  Schedule C is of even more interest to the IRS because if they can find errors here, they not only receive additional income tax, penalties and interest, but also stand to receive self-employment tax (social security and Medicare).

If your charitable contribution deductions are disproportionately large compared to your income, it does catch the eye of the IRS.  The IRS keeps record of what the average charitable contribution is for those in your income level and investigates further when a tax return reports deductions in this area well outside the norm.  Again, if the contributions are legitimate and documented, feel free to claim them.  Usually, the IRS will simply ask you to provide substantiation of the deduction via a notice in the mail.  At that time, you can simply provide them with copies of your documentation and the issue will be resolved.

If you receive a form 1099-MISC under your social security number with income that is ultimately reported on a partnership or S-corporation income tax return, be sure to report the 1099 revenue directly on your personal return and then back it off indicating that the income is reported on the separate business income tax return.  This will keep the IRS computers happy as they will be looking for this income on your personal return and you will be sent a notice of unreported income if it is not reported on the form 1040 return. Obviously, this income would be included in the gross revenue on the separate business return and the net income from the business will flow through to your form 1040 in the end in the form of a schedule K-1 from your business.

Lastly, certain industries lend themselves to increased IRS scrutiny.  This would include businesses that have high cash transactions as a percentage of their overall revenue.  Examples of this would be restaurants, bars, car washes, hair salons, taxis, etc.  Obviously, these industries present many opportunities for their owners to pocket certain cash received and not report it properly for tax purposes.  This is why the IRS tends to look more closely at these businesses.

In a nutshell, if you have nothing to hide, you have no reason to fear even when your return exhibits some of the characteristics mentioned above.  You should just know that these issues do make you more susceptible to IRS questioning and be prepared to respond with your documentation to satisfy their request.  Most examinations performed by the IRS are not in-person, full blown audits.  Much more often, you will receive a notice in the mail from the IRS asking you to provide backup documentation for some of the deductions you claimed on your return.  In these cases, you simply mail or fax in the documentation requested and the case is closed.

If you now have any open issues with the IRS or if you are concerned about certain deductions claimed on your return, feel free to contact me to discuss.  We provide IRS representation services to our clients and would be glad to help, when needed.

Thanks.

Mark J. Weech, CPA