It is that time of the year again, when the April tax filing season is upon us and interest in the IRS is at a yearly high. So you will likely see articles claiming to give you the “secret sauce” on how to avoid an IRS tax audit — by warning you of “red flags.” There articles are all fine, I suppose, if this was 2008. However, the IRS has changed drastically since then. In this article, we will discuss what the real audit "red flags" are, and what is just sort of things are outdated.
2008 marked the high-water mark of IRS examinations. However, since then, the IRS field auditors are dwindling in supply. What this means is that for most people who used to be under threat of an audit, really aren’t. However, a strange by-product is that certain people are in much more likely to be audited.
The philosophy of the IRS examinations used to be “to spread the misery” around equally. Everyone was subject to audit. But now, there is an entirely new way of thinking about how the IRS actually selects individuals to audit.
Old thinking: Ensure compliance all around
Now: Where is the highest return on investment (ROI) of auditors’ time.
So…what kind of assessments can be done automatically?
The highest ROI is usually find where no or few IRS employees are needed. For instance, the IRS has an Automated Underreporting Unit (AUR). Leaving off income items, like 1099s can result in an automatic adjustment. The IRS sends you a notice (usually a CP2000) to let you know they intend on increasing your income tax. The IRS also gives you an opportunity to contest the increase. A common area of controversy when the IRS doesn’t take into account your basis, or cost of the property you sold. If the IRS get a 1099s for you selling real estate and stock, the IRS may consider all of the proceeds as income. Yet we know this is very unlikely — real estate and stocks cost you something.
What aren’t really Audit Red Flags anymore
These things used to be Red Flags, but perhaps are now yellow flags. Why? Because it actually takes an audit to determine if it is worth it to audit you! The IRS would rather now for sure an audit will likely lead to an increase, not could. But likely.
- Higher than average deductions
- Claiming rental losses.
- Taking large charitable deductions.
- Hobby losses
- Deducting meals travel and entertainment
- Claiming 100% business use of vehicle
- Claiming professional trader in order to immediately utilize losses instead of being limited to $3000 per year offset.
- Not reporting gambling wins (may be subject to AUR assessment)
- Claiming home office deduction
- Large cash deposits
- Running a business
Things that we have seen that will greatly increase your chance of an audit, actual "red flags"
- Reported income over $1.0 million (1 in 17 of these returns that are filed are examined)
- Taking the Research & Development Credit (the IRS is loathe to grant this credit; but can be worth the audit risk if doen correctly)
- Owning Captive Insurance Company
- Having a Private Placement Life insurance policy
- Having someone "whistleblow" on you.
The biggest audit red flag
So what has the maximum ROI per employee hour worked? The answer to this question leads us to what we consider the biggest tax audit red flag.
From the IRS's perspective, it is very hard to beat foreign returns with foreign income — they can be penalty minefields — for maximum ROI.
Consider a person who has a foreign corporation and a foreign pension along with some assets overseas. Their return can be remarkably complicated.
Yet anyone can claim they know how to prepare, yet an expert on international taxation can look at a rookie-prepared return and find facial errors that would lead to an automatic $10,000 penalty. For example, it can be fairly easy it determine if a Form 5471, Form 8938, Form 3520-A, Form 3520, or a Form 926 are required to be filed, but was not. Additionally, it is fairly easy to determine if these forms are so substantially incomplete to be counted as not being filed.
And for these five forms — each has a $10,000 penalty that could be assessed — for multiple years.
So do you see how the IRS would be interesting in auditing an international return of moderate complexity?
The problem is that with foreign assets and income your options are to:
- leave it off and face the prospect of huge penalties that could destroy you if detected.
- Do it yourself or with some who is not an expert and hope for the best. Yet, reporting can increase your audit risk.
- Hire a firm that could be more expensive than an average tax firm, but actually experienced at winning IRS international audits that knows how minimize or eliminate any penalty exposure.
What if you haven’t been reporting foreign income properly?
The good news is that most people qualify for a streamlined disclosure program and this can really eliminate any penalty potential. We have submitted hundreds and not one of our Streamlined submission has been audited as of this writing.
If you have made a disclosure and you are worried it is not up-to-snuff and may actuall be used against you, there may be thing we can do to make your situation better. Feel free to contact us to discuss your issue, confidentially, with one of our international tax attorneys.