As you prepare to file your tax return, you may be curious about the likelihood of the IRS auditing your return. There may be heightened concern due to the Inflation Reduction Act, enacted two years ago and provided the IRS with an additional $80 billion in funds over ten years, with a significant portion allocated to increased enforcement activities.
These 19 red flags could increase the likelihood of the IRS selecting your return for an audit.
Earning a lot of money
While the overall chances of being audited by the IRS are quite low for individual taxpayers, the likelihood increases significantly as your income rises, especially if you have business income. It’s important to note that the IRS has allocated a significant portion of its additional funding over the next decade to enforcement activities and collection measures, indicating a focus on increasing audit rates.
The Treasury Department and the IRS have indicated that some of these enforcement funds will be utilized to audit more high-net-worth individuals and pass-through entities, such as LLCs and partnerships. Although officials have pledged that taxpayers earning under $400,000 will not see increased audit rates compared to recent years, it remains to be seen if the IRS will be able to fulfill this commitment.
Furthermore, the IRS’s high-wealth examination team is also ramping up its efforts, specifically targeting examinations of the ultra-wealthy. Revenue agents are taking a comprehensive approach by scrutinizing not only the 1040 returns of these individuals but also the returns of entities they control, both domestic and foreign.
It’s not about discouraging you from earning a higher income – everyone aspires to financial success. However, it’s important to understand that the more income you report on your tax return, the greater the likelihood of drawing the attention of the IRS.
Failing to file taxes
Historically, the IRS has not consistently pursued individuals who have failed to file their required tax returns, drawing criticism from Treasury inspectors and lawmakers for its lack of enforcement in this area over the years. As a result, it is now no surprise that high-income non-filers have become a top priority for the IRS in terms of strategic enforcement.
The focus is primarily on individuals who have received income exceeding $100,000 but have failed to file a tax return. Collections officers will reach out to these taxpayers and collaborate with them to address the non-compliance issue and bring them into adherence with tax filing requirements. Individuals who persist in non-compliance may face consequences such as levies, liens, or even potential criminal charges.
Failure to disclose all taxable income
It is important to ensure that you report all the income you are required to on your tax return, as the IRS has access to copies of all the 1099s and W-2s you receive. The IRS uses computer systems to compare the information on these forms with the income you report, and any discrepancies can trigger a red flag, leading to the IRS sending you a bill.
It’s worth noting that receiving such a bill does not constitute an audit by the IRS. If you come across a 1099 form that shows income that does not belong to you or contains incorrect income information, it’s important to request the issuer to submit a corrected form to the IRS.
When filing your 1040 return, it’s crucial to report all sources of income, even if you do not receive a specific form such as a 1099. This includes income from activities like dog walking, tutoring, driving for ride-sharing services like Uber or Lyft, teaching music lessons, or selling handmade crafts on platforms like Etsy. All such income is subject to taxation.
Claiming excessive deductions, losses, or credits
If your tax return’s deductions, losses, or credits significantly outweigh your income, the IRS may decide to scrutinize your return more closely. Large losses from the sale of rental property or other investments can also attract the IRS’s attention, as can substantial deductions for bad debts or worthless stock.
However, if you have legitimate documentation to support your deduction, loss, or credit, you should not hesitate to claim it. You are not obligated to pay more tax than what you genuinely owe, so it’s important to assert your rightful deductions, losses, and credits with confidence.
Claiming substantial charitable deductions
While charitable contributions are a commendable way to support causes and reduce tax liability, it’s important to be mindful of the proportion of your charitable deductions in relation to your income. If your charitable deductions appear disproportionately large compared to your income, it can raise concerns for the IRS.
The IRS has a good understanding of the average charitable donation for individuals within specific income brackets. Furthermore, failure to obtain an appraisal for valuable property donations or to file IRS Form 8283 for noncash donations exceeding $500 can increase the likelihood of being targeted for an audit.
Additionally, if you have donated a conservation or façade easement to a charity, or are an investor in a partnership, LLC, or trust that has made such a donation, your chances of being contacted by the IRS significantly increase.
The IRS has identified combating abusive syndicated conservation easement deals as a strategic enforcement priority. In fact, Congress has recently taken steps to disallow charitable deductions in the most egregious conservation easement cases.
Operating a business
For self-employed individuals, Schedule C offers a wealth of tax deductions, but it also attracts attention from IRS agents who are aware that some self-employed individuals may claim excessive deductions or fail to report all their income. The IRS scrutinizes both higher-grossing sole proprietorships and smaller ones.
Sole proprietors with at least $100,000 of gross receipts reported on Schedule C, as well as businesses that deal extensively in cash (such as taxis, car washes, bars, hair salons, and restaurants), face a higher risk of being audited. Similarly, business owners who report significant losses on Schedule C, especially if these losses can offset other income reported on the return, such as wages or investment income, are also at a heightened audit risk.
Furthermore, claiming 100% business use of a vehicle is a notable audit red flag for the IRS. It is uncommon for a vehicle to be used exclusively for business purposes, especially if no other vehicle is available for personal use.
The IRS also targets heavy SUVs and large trucks used for business, particularly those purchased late in the year, as these vehicles are eligible for more favorable depreciation and expensing write-offs. It is crucial to maintain detailed mileage logs and accurate calendar entries for the purpose of every road trip, as inadequate recordkeeping can lead to the disallowance of deductions by a revenue agent.
Failure to report professional earnings as self-employment income
The IRS is focusing on limited partners and LLC members who do not file Schedule SE or pay self-employment tax. An ongoing audit campaign is specifically targeting the issue of whether limited partners and LLC members in professional service industries are responsible for self-employment tax on their distributive share of the firm’s income.
In a 2017 ruling, the Tax Court determined that members of a law firm organized as a limited liability company, who actively participated in the LLC’s operations and management, were not merely investors and were therefore liable for self-employment taxes.
Similarly, in a recent ruling, the Tax Court held that limited partners who actively participate in a limited partnership could also be subject to self-employment tax. This particular case involved a hedge fund. IRS examiners have been scrutinizing LLC and LP owners in professional service sectors such as law, medicine, consulting, accounting, and architecture, conducting audits over the past few years.
Claiming a loss from a hobby
If you consistently report multiple years of losses on Schedule C of Form 1040 for an activity that appears to be a hobby and have substantial income from other sources, you are likely to attract the attention of the IRS. The IRS is particularly focused on taxpayers who repeatedly report significant losses from activities that resemble hobbies in order to offset other income, such as wages, business earnings, or investment returns.
The rules regarding hobby losses are frequently contested in the Tax Court, and while the IRS often prevails in court due to settlements in cases where it believes it may not succeed, taxpayers have also emerged victorious in several court cases.
In order to claim a loss, it is essential to demonstrate that the hobby is being conducted in a business-like manner and that there is a reasonable expectation of generating a profit. The law presumes that a profit motive exists if the activity generates a profit in three out of every five years (or two out of seven years for horse breeding), unless the IRS can establish otherwise.
Suppose these safe harbors cannot be met. In that case, the determination of whether an activity is appropriately classified as a hobby or a business is based on the specific facts and circumstances of each taxpayer. In the event of an audit, the IRS will require you to substantiate that your activity constitutes a legitimate business rather than a hobby.
Taking an early payout from an IRA or 401(k) account
The IRS is focusing on ensuring that individuals with traditional IRAs and participants in 401(k)s and other workplace retirement plans accurately report and pay taxes on distributions. There is particular scrutiny on early payouts before age 59½, which, unless an exception applies, are subject to a 10% penalty in addition to regular income tax.
The IRS is aware that many taxpayers make errors on their income tax returns regarding retirement payouts, with a significant number of mistakes stemming from individuals who do not qualify for an exception to the 10% additional tax on early distributions. This issue is receiving close attention from the IRS.
The IRS has a chart outlining withdrawals taken before the age of 59½ that are exempt from the 10% penalty. Examples include payouts for significant medical expenses, total and permanent disability of the account owner, or a series of substantially equal payments that run for five years or until age 59½, whichever is later. The recent SECURE 2.0 retirement savings legislation introduced additional exceptions to these rules.
Operating a marijuana business
This type of business presents significant income tax challenges due to federal regulations. Marijuana businesses are generally prohibited from claiming business write-offs, except for the cost of the marijuana itself, even in states where it is legal to sell, grow, and use marijuana. This is because a federal statute restricts tax deductions for sellers of controlled substances that are illegal under federal law, including marijuana.
The IRS is closely monitoring legal marijuana businesses that attempt to claim improper write-offs on their tax returns. During audits, agents may disallow deductions, and courts consistently support the IRS on this matter. Additionally, the IRS has the authority to use third-party summons to obtain information from state agencies and other entities in cases where taxpayers have refused to comply with document requests from revenue agents during an audit.
Failing to report a foreign bank account
The IRS is particularly focused on individuals with funds held outside the U.S., particularly in countries known for being tax havens, and U.S. authorities have been successful in obtaining disclosure of account information from foreign banks.
Failure to report a foreign bank account can result in significant penalties. It’s important to ensure that any such accounts are properly reported. This involves electronically filing FinCEN Report 114 (FBAR) by April 15, 2024, to disclose foreign accounts that collectively exceed $10,000 at any point during 2023. Taxpayers who miss the April 15 deadline are granted an automatic six-month extension to file the form. Additionally, individuals with substantial financial assets abroad may be required to attach IRS Form 8938 to their timely filed tax returns.
Engaging in cryptocurrency or other digital asset transactions
The IRS is actively pursuing taxpayers who engage in the sale, receipt, trade, or other transactions involving bitcoin, virtual currency, or other digital assets. In its efforts to address unreported income from these transactions, the IRS is sending letters to individuals believed to have virtual currency accounts and has established teams of agents dedicated to cryptocurrency-related audits. Furthermore, all individual filers are required to disclose on page 1 of their Form 1040 whether they received, sold, exchanged, or otherwise disposed of a digital asset.
For tax purposes, bitcoin and other cryptocurrencies are treated as property. The IRS provides frequently asked questions covering topics such as selling, trading, and receiving cryptocurrency, calculating gain or loss, determining tax basis when the currency is received for services, and more.
Misreporting the Health Premium Tax Credit
The premium tax credit, established over a decade ago, assists individuals in paying for health insurance purchased through the marketplace. Until 2021, the credit was available to individuals with household incomes ranging from 100% to 400% of the federal poverty level. From 2021 through 2025, some individuals with incomes over 400% of the poverty level may also be eligible for credits, depending on the policy’s cost. Those eligible for Medicare, Medicaid, or other federal insurance do not qualify for this credit, nor do individuals who have access to affordable health coverage through their employer.
When purchasing insurance on a marketplace website such as healthcare.gov, the credit is estimated, and individuals can have the credit paid in advance directly to the health insurance company to reduce their monthly payments. Subsequently, taxpayers generally need to include IRS Form 8962 with their tax return to calculate their actual credit, report any advance subsidy paid to the insurer, and reconcile the two figures. Any excess can be claimed on Form 1040 if the credit exceeds the premium advances. If the credit is less than the advances, most individuals will be required to repay all or part of the excess.
Misreporting the health premium credit is a red flag for IRS audits. The IRS’s computer systems flag returns showing incomes above the limit for taking the credit. Additionally, the IRS actively seeks individuals who opted to have their subsidy paid directly to the insurance company but failed to file an income tax return to reconcile the advances with the actual credit.
Claiming an alimony deduction
Alimony paid in cash or by check under pre-2019 divorce or separation agreements is deductible by the payer and taxable to the recipient, provided specific requirements are met. These include the payments being made under a divorce or separate maintenance decree or a written separation agreement, with the document not stating that the payment is not alimony. Additionally, the payer’s liability for the payments must terminate upon the former spouse’s death. The IRS is aware that many divorce decrees do not comply with these rules.
It’s important to note that alimony does not include child support or noncash property settlements. The rules regarding the deduction of alimony are intricate, and the IRS is vigilant about ensuring that filers who claim this deduction meet the requirements. The IRS also seeks to verify that both the payer and the recipient accurately reported alimony on their respective tax returns. Any disparities in reporting by ex-spouses are likely to trigger an audit.
Alimony paid under post-2018 divorce or separation agreements is not deductible, and ex-spouses are not taxed on alimony received under such agreements. In cases where older divorce agreements can be modified to adhere to the new tax rules, the IRS closely monitors taxpayer compliance with these changes. Schedule 1 of the 1040 form mandates that taxpayers who deduct alimony or report alimony income provide the recipient’s Social Security number and the date of the divorce or separation agreement.
Claiming the American Opportunity Tax Credit
The American Opportunity Tax Credit (AOTC) provides individuals with a tax break to help with the costs of higher education. This credit is worth up to $2,500 per student for each of the first four years of college. It is calculated based on 100% of the first $2,000 spent on qualifying college expenses and 25% of the next $2,000.
Additionally, 40% of the credit is refundable, meaning it can be received even if no tax is owed. The AOTC begins to phase out for joint-return filers with modified adjusted gross incomes above $160,000 ($80,000 for single filers), and the student must be enrolled at least half-time. Qualifying expenses include tuition, books, and required fees, but not room and board.
The IRS is increasing its enforcement efforts related to the AOTC, focusing on several problem areas. These include claiming the credit for more than four years for the same student, failing to include the school’s taxpayer ID number on Form 8863 (used to claim the AOTC), taking the credit without receiving Form 1098-T from the school, and claiming multiple tax breaks for the same college expenses.
Failing to report gambling winnings or claiming substantial gambling losses
Recreational gamblers are required to report their winnings as other income on the 1040 form, while professional gamblers must report their winnings on Schedule C. Failure to report gambling winnings can draw IRS attention, particularly if the casino or other venue has reported the amounts on Form W-2G.
On the other hand, claiming large gambling losses can also be risky. These losses can only be deducted to the extent that gambling winnings are reported, and recreational gamblers must also itemize to claim these deductions. The IRS is closely examining returns of individuals who report significant losses on Schedule A from recreational gambling but fail to include the winnings in their income. Moreover, taxpayers who report substantial losses from their gambling-related activity on Schedule C are subject to extra scrutiny from IRS examiners, who aim to ensure that these individuals are genuinely engaged in gambling as a profession.
Claiming rental losses
Under the passive loss rules, the deduction of rental real estate losses is typically restricted, but there are two significant exceptions. Firstly, if you actively participate in the renting of your property, you can deduct up to $25,000 of loss against your other income. This $25,000 allowance is phased out as adjusted gross income exceeds $100,000 and is completely eliminated once your AGI reaches $150,000.
The second exception applies to real estate professionals who dedicate more than 50% of their working hours and over 750 hours each year to materially participating in real estate activities as developers, brokers, landlords, or similar roles. They are eligible to write off rental losses.
The IRS closely examines substantial rental real estate losses, particularly those claimed by individuals asserting to be real estate professionals. The agency is reviewing the returns of individuals who claim to be real estate professionals and whose W-2 forms or other non-real estate Schedule C businesses indicate significant income. Agents are assessing whether these filers have worked the necessary hours, particularly in cases where landlords’ primary occupations are not in the real estate industry.
Claiming the Foreign Earned Income Exclusion
U.S. citizens working overseas can potentially exclude up to $120,000 of their income earned abroad on their 2023 tax return if they meet the criteria of being bona fide residents of another country for the entire year or being outside of the U.S. for at least 330 complete days in a 12-month period. Additionally, the taxpayer must have a tax home in the foreign country. It’s important to note that the tax break does not apply to amounts paid by the U.S. or one of its agencies to its employees who work abroad.
The IRS actively investigates individuals who incorrectly claim this tax break, and the issue frequently arises in disputes before the Tax Court. The IRS’s focus areas include filers with minimal ties to the foreign country they work in and who maintain a residence in the U.S. (excluding individual taxpayers working in combat zones such as Iraq and Afghanistan), flight attendants and pilots, and employees of U.S. government agencies who mistakenly claim the exclusion while working overseas.
Taking the Research and Development Credit
The research and development credit is a widely utilized business tax incentive, but it has also been identified by IRS agents as susceptible to abuse. The IRS is actively monitoring for taxpayers who fraudulently claim R&D credits and promoters who aggressively market R&D credit schemes. These promoters are known to encourage certain businesses to claim the credit for routine day-to-day activities and to inflate wages and expenses in the calculation of the credit.
To qualify for the credit, a business must engage in qualified research, which entails research activities reaching the level of a process of experimentation. Activities that do not qualify for the credit include customer-funded research, adaptation of an existing product or business, research conducted after commercial production, and activities lacking uncertainty about the potential for a desired result.
