What Triggers a Tax Audit?
A tax audit can be a stressful and confusing experience if you’re not familiar with the process. So, what triggers a tax audit anyway?
In this article, we’re taking a closer look at what triggers a tax audit so you know what to expect.
What Triggers a Tax Audit Anyway?
When the IRS decides to audit a taxpayer, they will typically review your returns for any irregularities, and aim to rectify them. In some cases, this may even result in a tax refund for the taxpayer in question. In most cases, the IRS may find that you’ve underreported income, or claimed a deduction you aren’t qualified for. In all cases, you have the right to disagree with their assessment, present the necessary evidence, and retain your tax balance.
Related: Learn more about Audit Reconsiderations.
One way or the other, there is nothing inherently worrying or malicious about a tax audit, and most cases don’t even require you to be face-to-face with an agent of the IRS. Many audits are conducted entirely via mail correspondence and may involve a simple request for additional information to verify a claim on your return or ask for your agreement on a simple correction.
When audits escalate into more serious allegations, it may be in your best interest to contact a tax professional to act as your representative. You want to ensure that you don’t pay more than you owe, and a tax professional can help you with that.
So, what triggers a tax audit anyway?
Exceptionally High or Low Income
The IRS audits very few taxpayers, relatively speaking. The agency audited roughly 0.45 percent of the individual tax returns they received in 2019, compared to about 0.59 percent the year before, and 1.11 percent in 2010. The number of audits the IRS performs has fallen drastically over time.
Nevertheless, the IRS does utilize certain criteria to filter out more suspicious tax returns. Exceptionally high and exceptionally low incomes may trigger greater suspicion. Those earning more than $1 million in 2017 were audited at a rate of 4.4 percent, for example, far higher than the average. Overall, most audited returns are those of taxpayers earning over $500,000 a year.
On the other hand, if you manage to reduce nearly all your income through deductions, or are a low-income taxpayer who has qualified for and claimed the Earned Income Taxpayer Credit (EITC), the IRS may pay close attention to ensure that you aren’t paying fewer taxes than you owe.
Tax and Information Return Discrepancies
The IRS relies on information provided by employers and companies to verify individual taxpayer returns. If you forget to declare income that your employer declared on a Form W2 or a Form 1099, for example, that might trigger a red flag in the IRS’s computer system.
The IRS additionally relies on large data sets gathered from various tax and information returns to determine average deductions and incomes for certain occupations. Exceptionally large or low incomes and unusual deductions might trigger an audit as well.
High Cash Deposits
Various businesses and institutions are required to notify certain federal agencies (including the IRS) if a transaction involving more than $10,000 has occurred. If this transaction falls in line with your income, it might not trigger an audit. But if it seems unusual for you, the IRS might want to dig a little deeper.
This triggers whenever a total of $10,000 is reached over a short amount of time, so “structuring” the deposits to avoid the trigger won’t work.
Claiming a Home Office Deduction
The home office deduction is one many might want to claim given the circumstances, but it is also one the IRS has historically examined with much scrutiny. To qualify for a home office deduction, you will want to ensure that the space you use to work from home is solely used for work.
There are quite a few details to get right if you want to claim this deduction, such as ensuring that the space you claim as a home office isn’t used for any other activities. This is the so-called exclusive use test, which requires that a specific area of your home be used only for your trade or business.
It need not be marked by a partition but must be a “separately identifiable space” – so you cannot claim a part of the kitchen or bedroom as your workstation. There are quite a few other things to keep in mind when aiming to qualify for a home office deduction, so be sure to review Publication 587.
Claiming You’ve Used Your Car Solely for Business
You must be careful when aiming to claim a deduction on your vehicle’s mileage and other costs. If you claim 100 percent of your vehicle costs as a business-related expense, the IRS will want proof that you are using your exclusively for business – especially if you only own one vehicle.
Be sure to keep clear records on when you’re using your car for business, and when you’re using it for personal use. If you’re claiming 75 percent of your mileage as a business expense, the IRS may require some proof to back this claim up. While tedious, this can save you thousands of dollars through a deduction the IRS might otherwise disallow.
You’ve Claimed a Paying Hobby as a Business
Certain hobbies can be quite lucrative, but there are clear tax differences between a hobby and a career. You cannot claim a hobby as a business – and thus cannot claim the tax deductions that come with running your own business – without first satisfying the IRS’s definition on what a business or career is.
If, for example, you’ve recently started making a substantial income through creating content on an Internet video platform like Twitch or YouTube, you will need to prove that you are putting enough time and energy into the endeavor to consider it a business, are living off of that endeavor, and are investing substantially in your former hobby to become more profitable (i.e. your primary motivation is to make money).
The IRS may also require that you’ve been earning a net profit from your hobby for at least three of the last five tax years for it to be considered a business. Naturally, if you’re audited, you will need records to back this up.
The IRS is particularly wary of foreign assets, especially assets in countries with tax laws that are advantageous compared to the US. In many cases, the IRS can and will access foreign account information for a US citizen, to ensure that you aren’t owing taxes on any of the money you’re keeping overseas. Some things to note:
If you have more than a cumulative $10,000 in overseas accounts, you must fill out FinCEN Form 114.
If you have overseas assets valued at $50,000 or more, you must fill out Form 8938.
While tax audits are rare, they aren’t necessarily something to be complacent about. If you have been audited by the IRS, then consider working with a tax professional to ensure that your rights as a taxpayer aren’t infringed upon.