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Worried About Getting Audited? Here Are Red Flags for the IRS.

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illustration by Sam Island

Even though the Internal Revenue Service is auditing fewer taxpayers these days, you still don’t want to put a target on your back.

Among those more likely to get audited: Small-business owners with lots of cash; landlords who persistently claim losses on rental properties; wealthy people who try complex tax maneuvers; and working-class taxpayers who claim the earned-income tax credit.

While the average audit rate has declined to 0.4% of returns from 1.1% over the past decade as the IRS grappled with declining resources, taxpayer complacency is dangerous, warns Ryan Losi, executive vice president of Piascik in Glen Allen, Va.

“There’s more reason for concern among some taxpayers than others, because enforcement efforts aren’t applied uniformly to all taxpayers,” Losi says. 

The IRS and accountants point to a number of strategies and circumstances that put taxpayers in the tax enforcer’s crosshairs.

Both Low and High Earners Are Targeted

There’s a barbell audit pattern across the income spectrum due to the kinds of credits, deductions and strategies that show up at different levels.

Those earning up to $25,000 annually are about five times more likely to get audited than taxpayers in the $25,000 to $1 million range, according to Syracuse University’s, Transactional Records Access Clearinghouse. 

That is because many lower-income folks are eligible for the earned-income tax credit, which the IRS believes is the source of some $17 billion in unwarranted annual claims.

At the other extreme, taxpayers with more than $1 million in income have an average audit rate of 2.2%, the highest of any segment, according to TRAC. The IRS says that is because higher-income tax returns are more likely to use more complex tax strategies.  

Schedule C Filers Get Special Attention

The IRS has always taken interest in self-employed taxpayers, such as small-business owners or freelancers, who must report income on a Schedule C. With the expansion of the gig economy in recent years, the agency’s appetite for rounding up unpaid tax obligations in this area is expected to increase, says Bill Smith, national director for tax technical services at CBIZ MHM.

“This is the easiest area for taxpayers to cheat,” Smith says. “If you’re paid in cash that’s easy to underreport, and taxpayers can make up expenses to bring a tax bill way down.” 

Major red flags are big losses, a high percentage of deductions against income, and write-offs of large costs such as a car, accountants say. Businesses with frequent cash transactions such as dry cleaners, hair salons, restaurants and mechanics also get scrutinized.

To scout out underreported income, the IRS requires hiring and payment platforms—such as Uber and Venmo—to report payments exceeding $20,000 or 200 transactions. For the 2022 tax year, that threshold falls to $600.

While the IRS’s access to more payment data may snag cheats, it can result in erroneous audit notices—so keep good records, says Frank Thomas, a certified public accountant at Thomas, Watson and Co. in Columbia S.C.  

“I have a client who created a


Shopify

account for his business, and he reported transactions to his S corporation return,” Thomas says. “The IRS claimed the income had not been reported because the revenue didn’t show up on his individual tax return.”  

Crypto Is a Hot Spot

A sharp rise in crypto activity is a likely trove of underreported gains and income, not necessarily due to willful noncompliance, says Sarah-Jane Morin, a partner at Morgan Lewis.

“There’s a lot of confusion,” she says. “A lot of people are surprised to learn that when you trade one cryptocurrency for another, that’s a taxable event.” 

To capture crypto transactions—which may trigger capital gains or income taxes—there is a checkbox at the top of Form 1040 asking if taxpayers were involved in crypto. To nab non-compliers, the agency has contracted Chainanalysis, a blockchain analytics company. 

“It can track money moved from address to address on the blockchain,” says Steve Larsen, a CPA at Columbia Advisory Partners.

Rental Losses Get Scrutinized

After last year’s frenzied real estate market, the IRS’s usual eye on rental losses is likely to sharpen, accountants say. Taxpayers with up to $100,000 in income who rent their properties can deduct up to $25,000 in losses.

But for folks who spend more than 50% of their working hours and over 750 hours a year managing their rental property, there is no limit on write-offs. It’s these folks who are likely to get scrutinized, says Nick Strain, a senior wealth advisor at Halbert Hargrove. “The IRS is going to want to know you’re putting in those hours,” he says. 

Foreign Financial Activities Shouldn’t Be Hidden

The IRS has a long history of chasing down assets stored in foreign bank accounts, and it comes down hard with penalties on those who try to hide them.

Taxpayers must disclose foreign bank or brokerage account on what’s called a report on foreign bank and financial accounts (FBAR) if there is more than $10,000 in combined accounts.

Errors and Oddities Can Result in Audits

Many audits are triggered by math errors or suspicious details, which can be detected by IRS computers.

Given the complexities of claiming pandemic stimulus credits and child tax credits on 2021 returns, error-generated audits are likely.

As for oddities, “things that are disproportional raise concern, like when you claim a small business loss for five years in a row,” Thomas says.

Beware of Certain Conservation Easements

The IRS has a special task force to audit 100% of individuals involved in syndicated conservation easements. These are twists on legitimate easements that allow landowners to receive a tax deduction for designating acreage for conservation.

 In February, seven taxpayers were indicted in a $1.3 billion easement scheme, according to the IRS. In total, the agency says that it uncovered $10.4 billion in fraud on a $636 million budget last year.

How long until you’re off the IRS’s audit radar when it comes to tax transgressions? Generally, three years, but if you underreport income by 25% or more, the lookback is six years. For fraud, there is no statute of limitations—the IRS can dig deep.

Write to editors@barrons.com

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