By Amy Fontinelle | Updated April 8, 2017
The Internal Revenue Service (IRS) collects about $7 for every $1 it spends on enforcement, so it’s no wonder the agency audited more than 1.2 million tax returns for 2015, often finding them through the use of IRS audit flags. Even though at present Chances of a Tax Audit [Are] Lowest in Years – Maybe Ever, it still pays to play it safe. Certain items will always put you at higher risk of an audit, such as having a high income or claiming travel and entertainment expenses for your business.
What you may not know is that the IRS also has specific enforcement priorities each year, generally based on areas in which it is losing a lot of money due to fraud.
IRS Audit Triggers for 2016 Individual Tax Returns
You should know about these five enforcement priorities so you can be extra careful about only claiming what you’re allowed to claim and keeping thorough records to support your return in case you are audited. This is not a complete list; rather, it’s a compendium of items that are likely to affect large numbers of taxpayers. (For more, see 10 IRS Audit Red Flags and 6 Big IRS Red Flags for Retirees.)
1. 100% Business-Vehicle-Usage Claims
“It’s a red flag to say you have a vehicle and use it 100% for business,” says enrolled agent, accredited tax advisor, and accredited tax preparer Abby Eisenkraft, author of “101 Ways to Stay Off the IRS Radar” and CEO of Choice Tax Solutions Inc. in New York City. While 100% business usage might be legitimate for a few people, most people will also use that vehicle to drive to and from work, and the IRS considers this a commuting expense, which is not a business deduction but a personal expense. People also commonly use business vehicles for personal errands. “To claim 100% business usage, you would need another vehicle to get to and from work and show that you didn’t use the business vehicle for personal use,” Eisenkraft explains.
The IRS specifies the rules for deducting the cost of a vehicle you use for business in Topic 510, Business Use of a Car. You can choose from two methods: the standard mileage rate (54 cents per mile in 2016) or the actual expense method. If you qualify to use either method, then you are encouraged to use the one that gives you the larger deduction. You must keep detailed records of your business vehicle use and expenses to substantiate your deduction. (For more, see What to Do If You Get Audited.)
2. Alimony Deductions
The first requirement for a payment to be considered alimony for IRS purposes is that it is stipulated by a divorce decree – in other words, it is not voluntary. The payer and recipient also must not file a joint return with each other and, if legally divorced, must not be members of the same household. The money must be specifically for spousal support – not child support, property support or some other form of payment. Alimony payments are deductible to the payer even if the taxpayer doesn’t itemize and are counted as taxable income to the recipient. IRS Publication 504 has further details.
“If you received alimony and omit reporting it on your tax return, it’s an easy crosscheck for the IRS,” Eisenkraft writes in her book. “The payer, who certainly wants the deduction, must report your name and Social Security number in order to get the deduction. The IRS will compare returns to make sure everything is in order.” Joshua Zimmelman, president of Westwood Tax & Consulting in Rockville Centre, N.Y., adds that if two ex-spouses unevenly report the payment and receipt of alimony, it may cause one or both parties to be audited. (For more, see Why People Don’t Lie on Their Tax Returns.)
3. Rental-Property-Loss Deductions
“The red flag of rental losses comes into play when someone claims to be a real estate professional when they have a few rental properties,” Eisenkraft says. People like to claim to be real estate pros so they can treat their real estate income as business income and gain more business deductions.
The IRS generally considers rental real estate activities to be passive activities – ones where you receive income from the use of tangible property rather than from providing a service. As a result of this categorization, you can’t usually deduct your losses unless you have income from other passive activities, such as trade or business activities in which you did not materially participate, to offset those losses. You can, however, carry excess losses forward to the next tax year.
The only time real estate rental income is not considered passive income is if you are a real estate professional, defined by the IRS as someone who performs more than 750 hours of real estate business per year and more than half of whose annual business activity is in real property trades or businesses in which that person materially participates. See IRS Publication 925 for details. The IRS will look at a number of factors, Eisenkraft says – including whether an individual has a full-time day job that is the source of most of his or her income and that accounts for most of his or her time – to see if the taxpayer truly qualifies for business treatment as opposed to passive activity treatment.
4. Large Schedule C Loss From an Activity That Looks Like a Hobby
Some people are tempted to classify their hobbies as businesses so they can deduct their expenses. If your hobby is consistently profitable, your deductions may be justified. If not, watch out.
The IRS defines a business activity as something you do primarily for income or profit and that you are involved in continually and regularly. The IRS will likely consider your activity a business that you engage in for profit if it is profitable for three out of five consecutive years. But that five-year period doesn’t begin until the first year when you show a profit, and you don’t get the benefit of the doubt until you have three profitable years.
These are just guidelines, not rules, but they are tricky, and you may need the help of a tax professional to glean how you’d likely be judged in an IRS audit. Furthermore, the IRS instructs its examiners to “be alert for situations where the taxpayer may have manipulated income and or expenses to meet the presumption rule determination.”
Just because your income comes from a hobby doesn’t mean you don’t have to report it; you do, on line 21 of form 1040. And you can offset the income associated with your hobby with the expenses associated with your hobby. You just can’t claim a loss for your hobby to offset your ordinary income.
Activities with a large tax benefit to the taxpayer or with large expenses and little or no income will be scrutinized more carefully. The IRS even lists certain activities that it deems to have a higher chance of actually being hobbies and not businesses: airplane charter, artist, auto racing, bowling, craft sales, direct sales, dog breeding, entertainer, farming, fishing, gambling, horse racing, horse breeding, motorcross racing, photography, rentals, stamp collecting, yacht charter, and writing.
Eisenkraft writes in her book that a former client of hers bragged about reporting a loss on a side business for 20 years. She says that while business can have losses, so many years of losses just means that the taxpayer hasn’t been caught yet. “If you haven’t made any profit in decades, that’s a good indication that you have no profit motive, no business acumen and it’s time to shut down. Or admit that it’s a hobby, not a business,” Eisenkraft writes.
5. Earned Income Tax Credit Claims
The IRS has experienced so much fraud related to refundable tax credits that it is delaying refunds this year to filers who claim some of them, including the earned income tax credit (EITC or EIC). Refundable tax credits are especially susceptible to fraudulent claims, because you can still get paid for them even if you have no tax liability, whereas other credits at best reduce your tax liability to zero. People commit EITC fraud by inventing a fake business or underreporting business income and/or by claiming someone else’s children as their own.
Taxpayers may qualify to claim the EITC if they have a limited amount of earned income: for example, a maximum of $44,846 in 2016 for taxpayers who are married filing jointly and have one qualifying child. This family would qualify for a credit of up to $3,373. Penalties for fraudulent claiming of tax credits include being barred from claiming the credit in future years and civil penalties.
Eisenkraft writes that the government can easily spot fraudulent returns, because taxpayers claim just the right amount of income to qualify. Using a tax preparer won’t spare you; you’ll get in trouble, and so will the preparer if you’re caught. Use the IRS’s EITC Assistant to see if you qualify to claim this credit. If you claim the EITC, be prepared to substantiate it with income and expense records for your business (if applicable) and with proof that the children you have claimed live with you and qualify.
Xavier Epps, owner of XNE Financial Advising in Alexandria, Va., and an IRS registered tax return preparer, says that the IRS will have more time this year to review in detail the returns of filers claiming the EITC and check systems to see if the person claiming the refund is due it. In the past the IRS would issue the refund and only later look into whether the taxpayer was qualified to claim it. (For more, see Are IRS Audits Random?)
How to Avoid Tax Trouble
“The best way for taxpayers to avoid making mistakes on these items is to keep all documentation and to remember to have an open dialogue with your tax preparer when preparing your taxes,” says Raymond Haller, a tax partner at accounting firm Grassi & Co. in Jericho, N.Y. “If your tax preparer believes you may be pushing the envelope, stop and ask yourself these questions,” he says:
Is the expense really ordinary and necessary, and do I have proper documentation to provide the IRS if I am audited? If the answer is no to either, then the question becomes:
Is saving a few thousand dollars in tax today worth the headache in the future if I am selected for audit and have to pay these taxes with penalties and interest plus additional professional fees to represent me?
Further, he explains, once you get on the IRS’s radar, it will likely audit you again in the future to make sure you’re complying with tax law. (For more, see Should You Represent Yourself vs. the IRS?)
The Bottom Line
A final note: Scammers love to use peoples’ deep-seated fear of an IRS audit to steal from them. Don’t talk to anyone who calls you saying they are from the IRS and don’t respond to any emails purporting to be from the IRS. Identity theft is another problem: Take immediate action by filing a police report and alerting the IRS if you receive any tax notices regarding a business you don’t own or a W-2 from a company for which you haven’t worked.
If you have any questions about the legitimacy of any tax-related notice or phone call, contact the IRS directly, using the information at IRS.gov, the official IRS website. (For more, see 5 Tips to Stay Safe From IRS Tax Scams.)