Tax Audit CPA discusses IRS Red Flags | how to avoid an IRS tax audit

IRS red flags …how do tax audit CPAs deal with them? First I’ll pass on some tips on how to avoid an IRS tax audit.

The IRS uses weighted statistical analysis to select tax returns for auditing by:

• Comparing your return to established national benchmarks.
• Comparing your return to Internal IRS benchmarks.
• Comparing your current to your past tax returns.
• Comparing your tax return to local benchmarks.

Each red flag adds to their DIF (Discriminate Function) score. The higher your score, the more likely your return gets audited. Ironically, E-Filing does the data entry for them. Exact parameters are confidential. Supposedly, you have a 1% chance of audit, even without red flags.

Hi, I’m Gary Bode, a tax audit CPA. I look for red flags on your return and double-check with you about accuracy. Prevention is the best tax audit defense.

I take all legitimate deductions and recommend:

• Good documentation by the client to IRS standards.
• Supplemental explanations on the tax return.

Sometimes you can Explain Away a Red Flag

Let’s say you have an S Corporation that claimed about 10,000 business miles on previous IRS Form 1120S(s). This year you have 32,000 business miles, all legitimate and well-documented. This would still be a red flag and could result in an IRS Correspondence Audit, where the IRS requests your mileage log. And of course, once they’re in the door, they may look at other areas of the return as well. An explanation as to why your company had more mileage could prevent that audit. Shouldn’t statistical analysis find that reason through other information on Form 1120S? Maybe. But a tax audit CPA would include the explanation anyway.

Here are areas that tax audit CPAs commonly believe raise red flags.

Filing Form 1040 with a Schedule C Loss

In general, there are multiple issues with Schedule C businesses. Consider becoming an S-Corporation instead. The IRS consistently cites that Schedule C(s) have a high audit rate. Why? That’s where the most tax preparation errors are.

Excessive Charitable Contributions

I recommend deducting all charitable contributions and then delineating them by name and amount on Schedule A. Even if each individual donation falls beneath the IRS threshold for reporting. This probably reduces the chance of an audit compared to, say, presenting the same amount as a lump sum and donated to “Various”.

Higher Income

Higher income returns have an increased chance of being audited than lower-income returns. I know this sounds unfair. Shouldn’t each return be examined carefully? Good documentation, professional CPA preparation and proactive explanations become increasingly important as your income increases.

Handwritten Returns

A handwritten return probably get more scrutiny, despite the fact that its data must be keyed in by the IRS. I think sloppy returns imply sloppy record keeping and poor math. Even if you’re not using a tax audit CPA to prepare your tax return, use some type of tax software.

Missing Information

The IRS revenue matching program requires employers, banks and brokerage houses, etc. to supply the IRS with copies of your W-2, Form 1099-INT and Form 1099-B, etc. If that information isn’t on the tax return, you would win the tax audit lottery. The IRS will send a polite Notice that recalculates your tax return and demands additional tax, interest and penalties.

Filing Early

Some folks think filing early in the season increases chances of an audit. And that might have been true 15 years ago. But statistical profiling means they can now accurately select erroneous returns instead of just fishing by time frame.

“I always assume my returns will be audited. So I keep well-organized documentation, and notes within the tax software. If the tax return is audited I’m confident all my numbers are good numbers.”
- Gary Bode, tax audit CPA

Filing Late

By late, I mean after all legitimate extensions. File on time.

E-Filing

Eventually the IRS will mandate E-Filing of all returns. Which makes their administration more cost efficient. But it also means more of your tax return is open for statistical analysis because you’ve done the data entry for them. Some tax audit CPAs think a paper return stands less chance of being audited. A taxpayer can elect to opt out of e-file and submit a paper return.

Amended Returns - Form 1040X

The IRS states it takes 8-12 weeks to process an amended tax return. Does this imply they look at Form 1040x more closely? Good explanations and support documentation are important. Tax audit CPAs generally include a cover letter on amended tax returns to present an overview of why the return is being amended.

Earned Income Credit

It’s one thing to reduce your tax liability to zero. It’s another thing to have the IRS give you money over and above what you’ve paid in. Originally designed for single Moms, the Earned Income Credit is an explicit area of IRS interest. Great care should be taken as “mistakes” can be criminal offenses.

Rental Property - Schedule E or Form 8825

In the past few years, loss on rental property has become common. Just lock down the documentation in case the IRS demands to see it.

Cash Industries

The IRS seems to think there is more cheating when folks deal with cash. Protection here is consistent reporting, year after year, and good revenue records. Credit card companies now provide Form 1099K to the IRS.

Employee Expenses

Generally, if you have work related expenses, your employer pays them. If not, track things like meal and entertainment expenses closely. Keep the receipts and credit card statements. Make notes on whom it was for and what was discussed.

Foreign Income

The IRS doesn’t have the same control of foreign banks and employers as they do with the domestic counterparts, YET. Good record keeping is crucial.

Rounded Numbers

Rounded numbers look like estimates or something pulled out of thin air. The IRS doesn’t like either reason. Use accurate figures from your tax documents.

I’m a tax audit CPA in Wilmington NC who serves a larger geographical base through a virtual office. I stay current on IRS red flags. For a free phone consult please call (910) 399-2705.