This article has been excerpted from Taxpertise: The Complete Book of Dirty Little Secrets and Tax Deductions for Small Business the IRS Doesn't Want You To Know , available from Entrepreneurpress.com .
The IRS will never tell you why a particular tax return is under audit. However, there are certain factors that make it obvious why a tax return was selected.
What Triggers an Audit?
Following is a comprehensive list of things that can trigger an IRS audit:
Failure to include income that has been reported to the Internal Revenue Service
During the month of January, you receive tax documents in the mail declaring income and certain expenses that relate to your tax return. For example:
- 1099-INT declaring the amount of interest income you've received from various sources including banks and investment companies
- 1099-DIV declaring the amount of dividends you have been paid on your investments
- 1099-MISC for work as an independent contractor and for rental income from tenants of your commercial properties
- W-2s and K-1s
The Internal Revenue Service receives this same information. When you file your tax return, the IRS plays a matching game to ensure that you have declared all of this income on your tax return. If you have not, the IRS will recalculate your tax liability and bill you accordingly. Also considered an audit, it's basically a by-mail correction notice that is open to dispute.
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Severe departure from the national standards
The IRS has a construction of tables, available on its website at irs.gov , that indicate by income level and if self-employed, by industry, an average of deductions taken in any given tax year. If your numbers are significantly different than the national averages, you may find your tax return up for scrutiny. Red flags include vehicle expense; charitable contributions, especially noncash ones; meals, entertainment, and travel; and excessively high cost of goods sold.
Dramatic change in income and expenses from one year to the next
You may experience a financial downturn that throws you into a loss situation. The IRS may audit just because it is interested in what happened and whether or not you are hiding income. Or if your income suddenly increases, the IRS may be suspicious that you cheated in the past and are now coming clean.
Lifestyle audits are supposedly a thing of the past. But come on, you know that lifestyle comes into play. I mean, if you are living in a Beverly Hills mansion, with mortgage interest of $200,000 per year, paying DMV fees on a Ferrari, and making charitable contributions of $50,000 each year, then your tax return had better show more than $36,000 of wages from Oil Changers, right? These incongruities will flag your tax return for audit.
Specific industry audits are a continuing IRS project. Every year the IRS selects a particular industry to audit. In recent history it has selected wage earners with a small Schedule C business (looking to blow hobby losses out of the water), attorneys incorporated as S corporations (looking at unreasonable compensation in order to add payroll tax liabilities), and trusts with offshore holdings (looking for tax fraud and unreported income).
Bonnie Lee is the founder of Taxpertise located in Sonoma, CA, a firm providing bookkeeping, payroll services, QuickBooks Training, income tax preparation, and tax problem resolution including audits, offers in compromise and other representation issues. She is also the author of Taxpertise: The Complete Book of Dirty Little Secrets and Tax Deductions for Small Business the IRS Doesn’t Want You to Know (Entrepreneur Press, 2009).