Understanding IRS Audit Flags (and How to Reduce Your Risk)

As we move through tax season, many of you may be wondering what catches the IRS's attention on a tax return. While an audit notice can be stressful, understanding common red flags can help you prepare accurate returns and maintain peace of mind.

Who Gets Audited Most Often?

While audits can certainly happen at random, the numbers are pretty clear: households earning over $5 million face the highest audit rates (a fate I’m sure most of us would be ok suffering from). Their returns tend to be more complex, with multiple income sources and sophisticated deductions that naturally require closer review. Business owners and self-employed are also audited at higher rates than standard W-2 returns.

Five Key Areas the IRS Watches Closely

1. Income Reporting
The most common issue involves missing or underreported income. While your employer automatically reports your W-2 wages, other income sources like freelance work, rental properties, investments and dividends require you to track and report them yourself. Make sure every 1099 form you receive is accurately reflected on your return. And if any income is received that isn’t shown on a 1099, you are still responsible for accurately tracking and reporting that.

2. Significant Income Changes
Did your income jump or drop substantially from last year? The IRS notices these fluctuations. If you lost a major client, sold a business, were granted stock options, or experienced another legitimate change, consider including a brief explanation with your return to provide context.

3. Ongoing Business Losses
New businesses often show losses in their early years, which is perfectly normal. However, year after year of losses raises questions about whether your venture is truly a business or perhaps a hobby. The distinction matters because hobby losses aren't deductible.

4. Deductions That Stand Out Three areas deserve special attention:

• Charitable contributions that seem unusually high for your income level, or that exceed IRS limits (60% of AGI for cash, 30% for property)

• Rental property losses when you're not substantially involved in management or don't meet specific IRS criteria

• Home office deductions which are only available if you're self-employed and your home is your primary business location (note this does not include employees who work from home)

5. Estate Valuations
Estate tax returns face heightened scrutiny, particularly around asset values. For items without clear market prices such as certain real estate, art, or private businesses, professional appraisals are essential. For high value or complex items, getting multiple appraisals may be prudent.

Your Responsibility

Even when working with a tax professional, you're ultimately responsible for your returns accuracy. Take time to review everything before signing. Good documentation isn't just about avoiding audits, it's also about being prepared if one occurs. The IRS statute of limitations is 3 years to initiate a normal audit, but that can be extended to 6 years under certain circumstances, or indefinitely if fraud is suspected. So it is considered best practice to maintain all records and documentation for at least 7 years. But the good news is that you don’t need to lose sleep worrying about a potential minor oversight on your 2015 tax return! 

If You Receive an Audit Notice

The IRS conducts three types of audits, ranging from simple correspondence by mail to comprehensive field examinations. Whatever the type, you'll receive advance notice of exactly what documentation is needed. If you work with a tax preparer, reach out to them first, as many offer some type of audit assistance.

Important: Be aware that scammers send fraudulent IRS letters. Real IRS correspondence never demands immediate payment, threatens jail time, or contains obvious errors. When in doubt, call the IRS directly at 800-829-1040.

The Bottom Line

Maintain thorough records, report all income accurately, and ensure your deductions are legitimate and well-documented. If you have questions about your specific situation, please don't hesitate to reach out. 

*Facts in this article are sourced from https://www.schwab.com/learn/story/how-to-minimize-risk-irs-audit

Investment advice is offered through Belpointe Asset Management, LLC. 500 Damonte Ranch Parkway, Building 700, Unit 700, Reno, NV 89521.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed