5 Slam Dunk IRS Audit Red Flags

5 Slam Dunk IRS Audit Red Flags

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Because in any given year the IRS is able to select for audit only a small percentage of tax returns, it employs a sophisticated system for choosing which returns to examine and which returns to accept as filed.

The IRS assigns a numeric value to each tax return known as a DIF score. Returns with a DIF score higher than a pre-specified number are flagged and sent to IRS regional examiners for further review and analysis.

The IRS examiners are trained to look for tax return items that indicate a high probability of error or fraud.

These items are known in the industry as “red flags.”

The 5 major red flags IRS examiners look for are discussed separately below.

Home Office Deduction

For most people expenses incurred in maintaining a home are non-deductible personal expenses.

However, if you use a portion of your home for business, you are entitled to deduct the costs related to that portion as a Home Office Deduction.

A Home Office Deductions (HOD) is a red flag because the IRS has determined that many taxpayers (and unscrupulous preparers) have historically used the HOD as a means of converting otherwise non-deductible personal expenses into deductible business expenses.

Thus, IRS examiners will carefully scrutinize all tax returns in which a home office deduction has been claimed.

All other things being equal, your chances of being audited are greater if you claim a HOD than if you don’t claim one.

Job Expenses

If you work for someone else and receive an annual Form W-2 showing the amount of wages you received and taxes withheld from your wages during the year, you are entitled to take a deduction for expenditures you made during the year in connection with the performance of your job only if the following three conditions are met,

  1. the total of all such expenses exceed 2% of your Adjusted Gross Income (AGI);
  2. the expenditures were “ordinary and necessary;” and
  3. the expenses were not reimbursed or reimbursable by your employer.

Like the HOD, Job Expense (Employee Business Expense) which is claimed as an itemized deduction on Form Schedule “A,” is a category of expense than lends itself to abuse.

Some taxpayers – usually traveling salesmen and commission based employees –  will claim as a deduction various outlays that are not reimbursed by their employer.

The IRS starts with the assumption that if an employer doesn’t reimburse a specific expenditure made by the employee in the conduct of his or her work, that expenditure is probably not a true job expense and, therefore, absent additional proof is probably not deductible.

Consequently, the mere existence of a Job Expense will cause an IRS regional examiner to more carefully scrutinize a taxpayer’s tax return.

This, of course, means that a tax return containing a Job Expense deduction is more likely to be audited than one that does not contain the deduction.

We have been called in to assist many taxpayers whose returns have been selected for audit solely because of an excessive Job Expense deduction.

And we have seen several tax preparers prosecuted for suborning a taxpayer’s claim of a fraudulent Job Expense deduction.

Rental Losses

Rental losses are subject to a number of complex rules of which even seasoned taxpayers sometimes run afoul.

The rental activities of most taxpayers will be considered passive and, therefore, the rental expenses associated with these activities will be deductible only to the extent of the rental income generated by them.

Taxpayers with passive rental losses who meet certain conditions are permitted to deduct up to $25,000 of excess rental losses. The $25,000 passive loss allowance is phased out for taxpayers with modified AGI exceeding a specified amount (roughly $150,000).

Some taxpayers by virtue of the time they spend managing and running their rental operations (the time spent is called “material participation“) will be considered to be in the business of renting real property (as opposed to passively renting real property) and these Real Estate Professionals are entitled to deduct their rental property losses in full.

In order to determine whether or not a particular taxpayer is in fact a material participant in his rental operations, the IRS requires the taxpayer to have spent a specified number of hours during the year in activities related to the management and operation of the rental property.

IRS regional examiners are trained to scrutinize tax returns in which taxpayers are claiming rental loss deductions greater than the $25,000 passive loss allowance.

If a taxpayer is a full time employee or is self-employed, the IRS deems it unlikely that he or she will have had the available time to materially participate in a particular rental activity.

Consequently, these taxpayers should expect their tax returns to be highly scrutinized and probably audited. 

Schedule C Expenses

Another area of historic abuse is the claiming by taxpayers of business deductions in excess of business income.

Taxpayers use Form 1040, Schedule C to do this.

If you are running a legitimate business and have a reasonable expectation of turning a profit, you may deduct the ordinary and necessary business expenses you incur in connection with operating that business.

Taxpayers who are employed by others (i.e. who receive a W-2 at year end) and who also claim a loss from a Schedule C business operation are likely to find their tax returns audited by the IRS.

We have seen taxpayers claim Schedule C expenses of more than 100 times the gross income derived from the enterprise; claim deductions on form Schedule C in a year when no income was reported as having been received; and attempt to classify their hobbies as businesses thereby converting otherwise non-deductible personal expenses into deductible business expenses.

In many if not most of these scenarios the taxpayer was represented by a purportedly qualified and scrupulous tax preparer.

Because there is so much abuse in the Schedule C loss area, we have adamantly recommended that taxpayers who are conducting a legitimate, for-profit business incorporate that business or form an LLC.

The mere reporting of businesses operations on Schedule C rather than a separate corporate tax return increases a taxpayer’s chances of being audited 50 fold.

Charitable Contributions

The last of the red hot 5 is charitable contributions.

This deduction has been historically abused by taxpayers because of two reasons:

  1. The documentation requirements have been lenient; and
  2. Taxpayers are entitled to claim a deduction for the fair market value of property they donate.

The IRS will scrutinize returns that include disproportionately large charitable contribution deductions.

Common Threads

Observant readers will have noticed two common threads running through the five items discussed above.

First, each of these items requires a subjective judgment to determine whether and to what extent a deduction is permitted. The more subjectivity involved, the greater the likelihood of mistake or outright abuse.

Second, at least with respect to the first 4 items, these deductions tempt taxpayers and unscrupulous tax preparers to try to convert personal, non-deductible living expenses into deductible expenses.

Final Thoughts

If you have legitimate home office expenses, job expenses, currently deductible rental losses, Schedule C losses and/or charitable contributions, you should consider the following before claiming them on your return:

  1. Are there are other items on your current year tax return or your last 2 years tax returns that you do not want the IRS to scrutinize? If the answer is yes, you might consider foregoing claiming any of the above deductions to avoid triggering of an audit;
  2. What is the comparative value of the deduction? Taxpayers should weigh (preferably with the help of a qualified CPA, lawyer or IRS enrolled agent tax preparer) the benefit of the deduction against the costs (monetary and psychological) that would be involved should the deduction trigger an audit.

If you do decide to take one or more of the above deductions, there are several things you can do to dilute their red flag status.

  1. Timely file your return;
  2. Use a recognized software program to prepare and print your return;
  3. File the return electronically;
  4. Have a respectable CPA, tax lawyer or IRS Enrolled Agent sign your return as tax preparer; and
  5. Attach explanatory statements to your return where necessary.
About Peter Pappas

Peter is a tax attorney and certified public acccountant with over 20 years experience helping taxpayers resolve their IRS and state tax problems.

He has represented thousands of taxpayers who have been experiencing difficulty dealing with the Internal Revenue Service or State tax officials.

He is a member of the American Association of Attorney-Certified Public Accountants, the Florida Bar Association and The Florida Institute of Certified Public Accountants and is admitted to practice before the United States Tax Court, the United States Supreme Court, U.S. District Courts - Middle District of Florida

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  1. I’m sure this is true. I’ve been audited 4 times now – all in years that I have rental property income or schedule C income. Always use home office expenses. However, if you document what you do, there is nothing to fear. Of the 4 times I was audited, 3 resulted in no change and the 4th resulted in additional refund to me.

  2. Paul,

    Thank you for visiting and commenting.

    I agree.

    If your returns are legitimate and well-documented, you should come out of an IRS audit unscathed.

    However, even if there are no negative adjustments, the process itself is stressful, time-consuming and costly.

    In short, even if you’re tax return is perfect, you don’t want to be audited.

  3. Paul –

    If you are audited once chances are you will be audited again – even if no change.


    Confused – are you saying it is better to pay more tax than necessary and not file a “perfect” and correct return than to risk a rare chance of being audited?

    Does not the IRS require that one file a correct return and claim all deductions to which one is entitled?


  4. Jeff Day says:

    Few things, I would like to take issue with:

    You State: “The mere reporting of businesses operations on Schedule C rather than a separate corporate tax return increases a taxpayer’s chances of being audited 50 fold.”

    I have seen on way too many times that a “CPA” got taxpayers to set up S-Corp etc, using above as reasons in of itself to do so. If the expenses/deductions are legitimate, they are legitimate. Period. And is it just a coincidence that the CPA failed to mention by setting up the new entity the taxpayer’s bill to him would go up by at least $600 per year? I wonder if the author of this article mentions to it’s clients when discussing: “now you do realize this will necessitate a very large increase in my fees do you not?”

    Mr Flach wrote: “Does not the IRS require that one file a correct return and claim all deductions to which one is entitled?”

    I have been to several nationwide forums with the IRS and have had many discussion concerning this “requirement” which in my opinion is a bunch of over-played crap. I have represented many taxpayers in audits. I can assure that I have never had an audit (sometimes going into appeals) that did not ultimately end up where I thought it should. Sometimes I have been @ the forums and preparers argue they only give the absolute minimum information required. I disagree, I think it is my responsibility to help the auditor arrive at the correct tax return, not the least they can get by with.

    But going back to Mr Flach’s remark, if it is my responsibility to help a taxpayer stay within the regs to take a deduction, it is my responsibility to help a taxpayer make it where he could not be required to take a deduction if it is in his best interests to not take the deduction. eg. a single parent taxpayer has an office in the home and makes about $50k we tell the taxpayer they can not utilize the office area for any other purposes, that means none. But on the other hand if the single parent’s income is aproximately $15k don’t I have a responsibility to advise they don’t use that space exclusively so they can’t take the deduction and let the earned income credit pay the self employment taxes, since there won’t be any income taxes anywhichways?

    I am making a second comment, concerning taking the decutions when required and would appreciate any feedback

    Jeff Day EA
    Evansville, IN

  5. Jeff Day says:

    I had a client some years ago, that was a single parent, she had a child about 11 yrs old, and worked at a convenience store. Her work hours ment that most days she was not at home when the child got out of school. Her income was aproximately $11,000 a year. Could she claim as a deduction on her tax return commuting expenses to work? Of course not that is silly.
    Her son was not doing well in school.

    She decided to stay at home and babysit 3 small children instead. Her income from the babysitting is aproximately the same as working for slave labor at the “gas station”. Her rent on her apartment did not change a single dollar. Her utilities did not change virtually at all.

    The question in play, is she “required” to allocate a percentage of the rental expenses to against the income? Although they were absolutely no different after daycare than before? Just because a middle income family is allowed to take the deduction on their mortgage when it didn’t change, she is required to “required” to take the rent?

    I say there is no daycare expense concerning the rental. Only the food purchases for the children not paid by either the state or the parents.

    Let’s pretend that instead of her being a daycare operator, she took up a rural newpaper carrier. We really do have those in the midwest. Her expenses to drive the route are virtually unchanged from driving to the gas station. She uses no more gasoline and doesn’t drive any more miles than she did. She still has the same “old clunker” carrying the still minimum state required liability insurance that she already did. Is she required to take a standard mileage deduction? Is she required instead to take an actual mileage expenses and keep gasoline receipts for the mileage of the route only?

    I maintain she does not have any auto expenses for the paper route and would not have any rental expenses.

    I maintain because she decides to stay at home and be there for her child she should not have negative consequences on tax return.

    Jeff Day EA
    Evansville, IN

  6. Jeff,

    Incorporating reduces a self-employed taxpayer’s chances of being audited, it does not eliminate them.

    It’s true that if you are audited and all of your deductions are legitimate you won’t owe anything to the IRS, but when we are talking about audit red flags the idea is not to get audited in the first place.

    I don’t advise my clients to incorporate so I can get an additional $600 or $700 in fees.

    I get triple that if my client is audited. Consequently, if I wanted to fatten my own wallet, I would advise them to do things that would increase, not decrease, their chances of being audited.

    And I certainly wouldn’t have written this post.

  7. Peter, I want to thank you for your professional response to my remarks. I know you not, therefore it was wrong for me to make any insinuations that inferred you would be any less professional.

    I did not mean to do that, but I can see after reading (putting thy foot in the mouth) I came across that way.

    Jeff Day

  8. Jeff,

    It’s cool.

    Sadly, there are professionals who do recommend courses of action just to increase their fees.

    Thanks for the comments and I hope you subscribe to my feed.

  9. What are the chances of being examined? A total of 1,391,581 individual income tax returns were audited during FY 2008 (Oct. 1, 2007 through Sept. 30, 2008) out of a total of 137.8 million individual returns that were filed in the previous year. This works out to 1.0% of all individual returns filed (about the same as the audit rate for the preceding year). Click here for more info.

  10. Mike,

    The chances are very low if you don’t have a red flag. But if, for instance, you are a W-2 employee who makes 50K per year and you show 30k of Schedule C losses, your chances of being audited are almost 100%.

  11. I know everybody needs to keep the tax records for 6 years. But for how may years does IRS usually go back to audit your tax return? do they usually audit mostly the previous year tax return?

  12. The IRS has 3 years from the date the return is filed to audit it. However, the statute is 6 years in the case of omitted income and overstatements of basis.

  13. The top audit topics in practice:

    Schedule C & Form 2106- Business Miles, Business Meals & Entertainment, Travel,
    Schedule A-Medical & dental

  14. Liz, thanks. I think that’s right on.

  15. I’m being audited for year 2011. I am a self-employed court reporter. I do freelance work. I have all receipts & records maintained & organized from my Schedule C but know the only discrepancy will be my business mileage. It will not match up to my business mileage log I’ve reproduced from my daily work sheets. I’m not sure what to do or how I will explain it. Should I just say “I don’t know.” I should have looked my return over better, but my acct is on the East Coast & files electronically w/out seeing it first. Then she mails it to me w/the page to sign. Needless to say, I’m getting a new CPA or accountant this year. Does this automatically mean I’ll be audited for other years too? I’d appreciate any advice.



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