Ever get that sinking feeling when you see an unexpected letter from the Internal Revenue Service (IRS)? It can be hard not to, even if you have no reason to fear an audit.
To have peace of mind during tax season, it’s important to know how the IRS selects people for audit. It’s also important to make sure you aren’t one of them.
“What people don’t understand is there’s no human beings involved in selecting a tax return for audit,” said David Klasing, certified public accountant and tax attorney. “That’s all done by computers using statistical analysis software, and there’s an expression out there in the profession — pigs get fat, hogs get slaughtered.”
Klasing says every tax return gets a numerical score with the worst being 999, then 998, 997 and so forth. Government audits will typically start with the 999s and work their way down from there.
Here are some of the red flags that to avoid when doing your taxes this year:
When the IRS sees neat, round numbers all over a tax return, that’s a red flag.
“If you own a business and you put a whole bunch of round numbers on a tax return, I’m talking everything … ends in zero,” Klasing said, “the IRS computer will look at that and say one of two things is happening: Either somebody’s pulling numbers out of their rear end and slapping it down on the return and they’re not real, or somebody is using estimates.”
He added that estimates can be appropriate in certain situations, but estimates must be reasonable and must be disclosed.
Working from home
The COVID-19 pandemic has kept many people working from home, but taxpayers have to be careful when it comes to itemizing.
“I would say the home office deduction is one that leads to a lot of audits,” Klasing said. “If your employer gives you an office outside the home to work in, you don’t get to deduct the home office as well.”
You can only claim this deduction in very specific situations, for instance if you’re self-employed, or you work as an independent contractor. In fact, the IRS says anyone who receives a W-2 (and does not generate income from a side business, gig work or some other form of self-employment) is not eligible for a home office deduction, even if they’re working from home during the pandemic.
If you do indeed qualify, Klasing said you heed to make sure the office is dedicated for work, with nothing of a personal nature — no televisions, no video games, no gaming computers. “The only thing that goes on in that space is work,” Klasing said.
When it comes to red flags the IRS is looking for, becoming a habitual scofflaw can be dangerous.
With no ramifications, a tax evader might continue to employ the same tactics and “by the time they get caught they’re so far away from that line of, ‘this is negligent behavior and they didn’t understand the law’ versus ‘this is willful income tax evasion and they should go to jail,'” Klasing said.
Creating a pattern of tax criminality only makes the government’s job easier by ruling out the possibility of an honest mistake.
Thinking about deducting health insurance expenses? Make sure you follow the IRS guidance on this one.
You may be able to deduct expenses you paid during the year for medical and dental care for yourself, your spouse, and your dependents, but make sure to deduct only the amount of your total medical expenses that exceed 7.5% of your adjusted gross income.
See the following eligible expenses on the IRS website.
Thinking about claiming a charitable donation on your next tax return? If it was more than $250, make sure you have written acknowledgment from the charity.
The IRS is also on the lookout for people claiming to have donated large, unlikely sums.
“I see people crossing the line with that one all the time,” Klasing said. “If you’re making $30,000 a year but yet giving $20,000 a year to your church, they’re not going to buy it.
Keeping money in an offshore account isn’t illegal, but that doesn’t mean you don’t have to pay taxes on it.
“There’s all this required foreign information reporting,” Klasing said. “An offshore account with more than 10 grand … [you need] an FBAR” — a Report of Foreign Bank and Financial Accounts — “for bank account reporting.”
Even if you generated no taxable income, the IRS requires those with offshore accounts of $10,000 or more — at any time during the tax year — to file an FBAR.
“They’ll get you for criminal charges for the foreign information reporting and can check for criminal charges for not picking up the offshore foreign income.”
He added that he’s seen the government, in some cases, levy 100% penalties on offshore accounts.
How can you protect yourself?
“What I tell all my clients is prepare every return like it’s going to be audited,” Klasing said, “and you should have no fear of an audit. If you knew you were going to be audited, what type of tax return would you prepare?”