Common Audit Triggers for Individuals and Small Businesses

Tax audits can be unexpected, stressful, and intimidating for both individuals and small businesses. While the IRS conducts audits for various reasons, understanding the common triggers can help you avoid potential pitfalls. This article details the key reasons individuals and small businesses face audits and offers tips to minimize your risk.

Underreporting Income

One of the most significant triggers for an audit is underreporting income. This often happens when taxpayers fail to include all their earnings on their tax returns. The IRS receives copies of income reports, such as W-2s from employers and 1099 forms from clients or financial institutions. If the amounts reported by these entities don’t match what you report, it raises a red flag.

What you can do:

  • Document All Income Sources: Keep detailed records of every income source, no matter how small. This includes freelance work, side jobs, and investment income.
  • Cross-Check Reports: Before filing, ensure that your reported amounts match the documents you’ve received from third parties.

Excessive Deductions

Claiming excessive deductions is another common reason for audits. When deductions appear unusually high compared to your income level or industry standards, it can attract scrutiny from the IRS. For instance, if business expenses are disproportionately large relative to revenue, the agency may question their validity.

What you can do:

  • Understand Typical Deductions: Research what constitutes reasonable deductions for your profession to avoid over-claiming.
  • Maintain Documentation: Keep receipts and records for all claimed deductions. Thorough documentation helps defend against potential audit queries.

Self-Employment

Self-employed individuals face a higher risk of audits compared to traditional employees. This increased scrutiny often stems from the complexities of self-reporting income and expenses. If a self-employed individual reports losses for multiple consecutive years, it raises concerns about the legitimacy of their business.

What you can do:

  • Track Business Expenses Carefully: Keep detailed records of all business-related expenses to substantiate your claims.
  • Be Prepared to Justify Losses: If your business has been operating at a loss, be ready to explain the situation and provide documentation to support your claims.

Round Numbers

Using round numbers in your tax return can appear suspicious. The IRS prefers precise figures, as they indicate accuracy and thoroughness in reporting. Round numbers can suggest that estimates were used rather than actual figures, leading to further investigation.

What you can do:

  • Use Exact Figures: Report exact amounts when detailing income and expenses to convey accuracy.
  • Double-Check Entries: Review your return to ensure all figures are accurately recorded.

Claiming Home Office Deductions

The home office deduction can be beneficial for many self-employed individuals and small business owners. However, it is also a common audit trigger, especially if the space doesn’t meet IRS criteria for a legitimate home office. The IRS investigates these claims to ensure they are valid.

What you can do:

  • Meet IRS Criteria: Ensure your home office qualifies as a dedicated space for business use and document its size and usage.
  • Keep Detailed Records: Document the business activities conducted in your home office and maintain records of related expenses.

High Charitable Contributions

Charitable donations can provide significant tax benefits, but claiming contributions that are disproportionate to your income can raise suspicions. The IRS may question whether the donations are legitimate or inflated to reduce tax liability.

What you can do:

  • Document All Donations: Keep receipts and records of all charitable contributions, including the organization’s details and the amount(s) donated.
  • Understand Contribution Limits: Be aware of the limits on charitable deductions relative to your income to ensure your claims are reasonable.

Frequent Amendments

Regularly amending tax returns can signal to the IRS that there are inconsistencies or issues with your original filings. Frequent changes may lead to increased scrutiny and a higher likelihood of an audit.

What you can do:

  • Review Before Filing: Take the time to thoroughly review your return before submission to minimize the need for amendments.
  • Keep a Record of Amendments: If you must amend a return, document the reasons clearly to help clarify any future inquiries from the IRS.

Discrepancies with Other Filers

Discrepancies between your tax return and those of other taxpayers, such as business partners or co-owners, can trigger an audit. If the IRS notices inconsistencies in how income or expenses are reported among multiple filers, it may lead to further investigation.

What you can do:

  • Communicate with Partners: Ensure that everyone involved in a business is on the same page regarding income and expenses reported on their tax returns.
  • Review All Related Filings: Before filing, verify that all parties have consistent and accurate information.

Large Cash Transactions

Businesses that operate primarily in cash or engage in large cash transactions may attract IRS scrutiny. The agency may question income reporting in these situations, especially if it seems inconsistent with reported expenses.

What you can do:

  • Document Cash Transactions: Keep meticulous records of all cash transactions, including receipts and documentation to support income reporting.
  • Use Bank Accounts for Transactions: Whenever possible, conduct business transactions through bank accounts to create a clear paper trail.

Claiming Losses in Multiple Years

Reporting business losses for several consecutive years can indicate to the IRS that the business may not be legitimate. This situation often raises questions about whether the business is being operated as a hobby rather than a legitimate enterprise.

What you can do:

  • Prepare Justifications: If you find yourself reporting losses over multiple years, be ready to explain the circumstances and provide documentation to substantiate your business operations.
  • Consider Your Business Structure: Regularly assess your business model and operations to determine if adjustments are necessary for profitability.

Inconsistent Information

Discrepancies between the information you report on your tax return and the data available to the IRS can lead to an audit. This includes mismatched Social Security numbers, incorrect filing statuses, or discrepancies in reported income figures.

What you can do:

  • Double-Check Your Information: Before filing, carefully review your return for any inconsistencies or errors.
  • Match Documents with IRS Records: Ensure that all reported information aligns with the data the IRS has on file.

Conclusion

While the thought of an audit can be overwhelming, understanding the common triggers can help you to navigate the tax filing process with confidence. By maintaining accurate records, reporting all income, and avoiding excessive deductions, you can significantly reduce your risk of attracting IRS scrutiny.

Taking these proactive steps enhances your overall financial health. Whether you are an individual taxpayer or a small business owner, adopting these best practices can help you manage your tax responsibilities effectively, allowing you to focus on what truly matters: growing your business and achieving your financial goals.

Further Reading

Common Tax Scams and Fraud Alerts

 

Additional Resources

For extra help, you can always visit the IRS website or contact a tax professional to assist you. 

 

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Kayla M. Pham / admin@rataxandaccounting.com

Administrator

RA Tax and Accounting, Inc.