The Fear of a Tax Audit
Did you know that paying your annual taxes could cause stress and high blood pressure? It’s the fear of a tax audit that gets under people’s skin, the gnawing feeling that they did something wrong. It’s that fear that even the smallest mistake may lead them to have a dreaded “tax audit by the evil IRS.” The IRS (Internal Revenue Service) indeed has a notorious reputation, but in reality, tax audits are rare.
Every year audits occur less and less. We’re talking about at least one million tax returns less than the year before. In other words, each year the IRS audits millions of tax returns less than they did the year before, so panicking is unnecessary, and the chance of an audit happening is infrequent. Since the IRS doesn’t have the resources it once did, and the number of audits has gone way down. That’s good news for those taxpayers who fear audits.
People Do Receive Audits
Unfortunately, there are still instances where people are audited; taxpayers should be aware of these tax audit triggers so that they can understand how to report these items correctly or avoid them altogether if they should.
In other words, know what you are supposed to claim or deduct, and be aware of what you do claim. Also, be aware of what documentation you must have and know the requirements you need to meet. If you don’t have the right supporting material, don’t claim you do.
Similarly, if you don’t meet the IRS requirements for a deduction, don’t take it. It’s as simple as that. It’s a good idea to get familiar with these audit triggers so that you can feel at ease this year when filing your taxes.
After all, if you do something wrong on your taxes and have a bad audit, wouldn’t you like to know what you did so that you could avoid it in the future? Be aware of all tax audit triggers and how to prepare for them if you have no choice. If you are taking a risk on one, make sure you are doing it right. Keep excellent documentation and follow the rules. Check out the IRS website for a complete list of all laws and regulations when it comes to taxes.
Tax Audit Trigger #1a. Business Expenses Mixed with Personal Expenses: Normal Issues
Blurring the lines between business and personal expenses may give the IRS a reason to take a closer look at your tax deductions. The agency uses business codes to measure typical amounts of deductions by profession; a tax return showing 20% or more than the norm may warrant a second look.
Deducting and reporting too many business expenses can raise a red flag with the IRS. To be eligible for tax deductions for your business, purchases must meet two requirements. The first one is that it must be necessary for your business. The second requirement is that it must be normal for your business.
So ask yourself before deducting business expenses the following questions: (1) Was the expense required for the conduct of the business? And (2) Was the purchase appropriate and common in the trade or business?
Those questions should help you determine if the business expense is deductible or not. The IRS will take a closer look at any expenses that don’t meet both conditions. Also, you cannot claim a hobby as a business expense even if you feel it meets both questions.
Here’s an example of how these questions can help you determine what is okay and not okay to claim for business expenses. A professional artist can deduct paint, brushes, and canvases since those items meet those two requirements. They are required to make art, and they are very normal for any artist.
Tax Audit Trigger #1b. Business Expenses Mixed with Personal Expenses: Auto Issues
Another trigger notorious for bringing audits on is the use of a car or truck for business purposes. Many people try to deduct 100% of business use on a company car. However, using a car solely for business purposes is a rare occurrence. While many people do use their cars as part of their business, they usually also use cars to take their children to daycare which is not okay.
You can deduct business expenses for your vehicle in one of two ways:
1. Actual Automobile Expenses Method: When using this method, first, add up your entire vehicle operating expenses, which can include interest on your loan (or cost to lease a vehicle), gas, insurance, maintenance, repairs, etc. Second, divide any miles you drive solely for business purposes by the total miles driven. Finally, apply that percentage to your operating costs. This number becomes your allowable deduction.
2. Simplified Vehicle Mileage Expenses Method: Using this method, you apply the current IRS-mandated mileage rate to the total miles driven for business in the calendar year. For the tax year 2019, the standard mileage deduction is $.58 per mile of business use.
If you do claim 100% business use on the depreciation form for your car, you keep diligent records. You must keep track of all mileage used for business purposes in a vehicle log. This can be as easy as jotting down the miles, dates, and descriptions into a notebook. You can also purchase software to track your mileage. Be sure to record the purpose of each trip. If you keep excellent documentation, you should have nothing to fear even if you do get a tax audit.
An example of how you could use your company vehicle correctly if you want to deduct it at 100% is if it is only used for driving clients to business places, but it isn’t okay if you sometimes get your hair and nails done on your way to work even if you feel that you must look pretty for clients. This does not count as a business trip.
Business meals may be allowed, but exceeding the occupational norm by a large amount invites a tax audit by the IRS. For example, since business meals can often be a blurred line, be sure to document what is and is not a business expense.
The IRS can be very strict when it comes to mixing business and personal expenses, so know what you can and cannot claim before you make any business deductions.
Tax Audit Trigger #2. Cash Business
The IRS is more likely to examine your tax return is you own a cash business. The reason being is because it is much easier for a business that deals in cash to hide or misreport income. Instead of receiving your standards 1099 forms, you receive $50 for a manicure you did.
Cash business examples are bars, convenience stores, nail salons, beauty shops, car washes, taxi services, dispensaries, laundry mats, house cleaning services, and restaurants.
An IRS red flag may go up if your lifestyle is such that your reported income just cannot pay all of your bills. If you work at a small, reasonably popular hair salon and drive a Ferrari, the IRS may take notice.
Tax Audit Trigger #3. The Computer Trigger: the DIF System
The IRS has a computer system called DIF (Discriminant Information Function). This computer program catches anomalies, duplicate information, and deductions and credits that just do not make sense by scanning tax returns.
An example would be when someone who earns $55,000 per year and gives away $45,000 to charity. This seems unlikely. This will make the DIF system raise a red flag, and human IRS agents will review the details that DIF found.
Tax Audit Trigger #4.Earning Over $200,000
The IRS audits about 1% of those earning less than $200,000 and audits almost 4% of those earning more, according to the IRS’s website. Similarly, for those who earn $1 million or more, the audited tax returns increase to 12.5%. Likewise, the same pattern exists for those who file business tax returns: 1% of corporations with less than $10 million in assets, compared with 17.6% above the threshold.
Tax Audit Trigger #5. Hobby Claims
When it comes to hobby losses, the IRS has some very specific rules and guidelines for what qualifies as a business expense and what’s just an expensive hobby. Some hobbies, like animal breeding, will often generate increased attention. Many tax rules determine the difference between a business and a hobby.
The basic rule is that losses are limited to the income from the hobby, how the activity is carried out, the expertise of the taxpayer, the time and effort expended, the expectation to profit, the history of the income or loss, and the elements of the personal pleasure or recreation.
Your hobby is not considered a business if you have not shown a net profit from it in at least three of the last five tax years. There is an exception if you are breeding horses. If you are in this category, you must show a net profit from it in at least the last two of the last seven tax years.
If you are in the first year at your new business (hobby), you can file Form 5213, which will give your hobby four more years to earn a profit.
The IRS won’t deem your hobby a business if you do not depend on the income from it to pay the bills or if you do not commit the required time, effort, and money to turn a profit. Have all of the documentation on hand at any time, because you may need it for an audit.
Tax Audit Trigger #6: Out of the Country Business
In previous years, the IRS was a bit more lenient when it comes to assets or cash in another country, even those who have more favorable tax laws than that of the United States, but now, the IRS has wised up. There are new rules for overseas assets.
The Foreign Account Tax Compliance Act has strict reporting requirements for foreign bank accounts. For one thing, the law requires overseas banks to identify American asset holders and provide information to the IRS. This way the IRS can access your account information from a foreign bank.
Also, taxpayers must report all foreign assets that are worth at least $50,000 on Form 8938. All foreign accounts with total cumulative balances of more than $10,000 must be reported on Form 114.
To report any out of country business on tax forms, you must check the box stating that you have foreign assets and you must identify the institution you used or are still using plus the highest dollar amount you had during the previous year.
These regulations force honesty, which may increase the likelihood of an audit. This is because many taxpayers with foreign accounts have tried hiding offshore income and assets.
Compliance with this law may increase the likelihood of an audit, but noncompliance with this law can result in steep penalties and possible legal consequences. Therefore, it’s best to play it safe and follow the law completely. When you file, double-check with the bank to make sure that your account balances are what you are claiming them to be.
Additional IRS audit triggers can be found at the following link.
Tax audit triggers can lead to audits, but just because you are being audited doesn’t mean you did something wrong. While many taxpayers are fearful of the IRS, very few get audited. Only 1% of taxpayers under $200,000 face an audit.
Avoid small tax return mistakes. Check out this link for more information:
Taxpayers should worry less about whether they will be audited or not, and more concerned about having the proper supporting documentation. An audit is no big deal if you have the proper paperwork to back it up. This means having the right mileage logs, books, account records, bank statements, receipts, etc. Have it ready and available, and you’ll have a stress-free tax season!