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The Top Five Tax Audit Red Flags By Aleksandra Todorova Published: February 1, 2007 EVERYONE CRINGES AT the thought of an IRS audit. The good news is, Only a tiny slice of tax returns — just 1% in 2006 — get audited Each year. The bad news? Audits are on the rise: up 6% in 2006, compared with 2005. "Field audits," the most feared type of audit where you actually sit down with an IRS officer, were up 23%, according to IRS statistics. So what can you do to slip under the IRS radar? Granted, what singles out a specific tax return versus another is a tightly-guarded IRS secret. But there are several red flags that tax experts say are likely to attract unwanted attention. Here are five. 1. Home-office deductions If you are self-employed and use part of your home as an office, you may be able to deduct some of your home expenses, including a portion of your utility bills, insurance and repair costs. The problem is, the requirements for this deduction are very specific and filers may claim it without being eligible, says Greg Rosica, contributing author of the Ernst & Young Tax Guide 2007. As a result, taking a home-office deduction, especially when you're employed by someone ...
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The Top Five Tax Audit Red Flags
By Aleksandra Todorova
Published: February 1, 2007
EVERYONE CRINGES AT the thought of an IRS audit. The good news is,
Only a tiny slice of tax returns — just 1% in 2006 — get audited
Each year. The bad news? Audits are on the rise: up 6% in 2006,
compared with 2005. "Field audits," the most feared type of audit
where you actually sit down with an IRS officer, were up 23%,
according to IRS statistics.
So what can you do to slip under the IRS radar? Granted, what
singles out a specific tax return versus another is a
tightly-guarded IRS secret. But there are several red flags that tax
experts say are likely to attract unwanted attention. Here are five.
1. Home-office deductions
If you are self-employed and use part of your home as an office, you
may be able to deduct some of your home expenses, including a
portion of your utility bills, insurance and repair costs. The
problem is, the requirements for this deduction are very specific
and filers may claim it without being eligible, says Greg Rosica,
contributing author of the Ernst & Young Tax Guide 2007. As a
result, taking a home-office deduction, especially when you're
employed by someone other than yourself, may flag your return for
more careful inspection.
The deal-breaker for home-office deductions: Even if you work from
home regularly, you're out of luck if your employer provides you
with an office space. "You can't just set up a home office because
you want to," Rosica says. "It needs to be done because your
employer wants you to do that, for the convenience of the employer."
If you don't have an office space at work - say your company has an
arrangement with you to do your work remotely — then a home-office
deduction is legit. (Should the IRS want proof of that and it isn't
outlined in your contract, a letter from your employer will do.) You
are also eligible if you're self-employed and work from home. For
more details on claiming this deduction, read our story "Home Office
Deductions."
2. Business losses and hobbies
So you're venturing into photography as a sideline business but it
hasn't quite taken off yet. Can you deduct your losses? Be careful:
If you report a business loss, that may flag your tax return for an
IRS audit, says Eric Tyson, author of "Taxes 2007 for Dummies." "The
IRS is well aware of the fact that there are people out there
promoting the notion of engaging in a sideline business for the
purpose of generating tax deductions," he says.
A sideline business can provide you with a nice tax break; you can
declare a loss even if the business generated no income for that
year. But there's a catch: Your business has to be profitable in at
least three of the past five years to be considered legitimate.
Otherwise, the IRS will consider it a hobby, not a business, says
Mark Luscombe, principal federal tax analyst with tax publisher CCH.
The difference is, with a hobby you can only deduct losses up to the
amount of the income it brought in. If you do declare a loss, be
sure to keep all your receipts ready in case the IRS decides to
investigate.
3. Noncash charitable contributions
The rules of deducting charitable contributions are pretty
straightforward when you're giving cash: Keep your receipts or
canceled checks for anything below $250; for contributions of $250
or more, you'll need a letter from the charity. (More details in our
story "The Perks of Charitable Giving".)
But what if you're donating clothes or other noncash items? The IRS
is tightening the rules. For donations after Aug. 17, 2006, you
can't claim a deduction for used clothing or other household items
that are not in "good" condition or better. That applies to donating
furniture, appliances, clothes and similar items. So, now, more than
in previous years, the IRS is likely to examine closely tax returns
that contain noncash donations, says Donna LeValley, a tax attorney
and contributing editor to "J.K. Lasser's Your Income Tax 2007."
Needless to say, that doesn't mean you shouldn't claim a deduction
for legitimate charitable contributions. Just be sure not to inflate
the value of those old sweaters.
4. Excessive deductions
It's that simple: Deduct too much compared with people in your
income bracket, and you may find yourself audited by the IRS. "For
any item that you put on your return, the IRS has built into its
computers a range of what they consider reasonable values, based on
your income and the type of deduction," says CCH's Luscombe. While
the exact ranges are a closely-guarded secret, tax experts point to
averages as a guideline. If your income in 2004 was between $30,000
and $50,000, for example, the folks in your income group deducted an
average $2,100 in charitable contributions and $5,300 in medical
expenses. (The latest year for which the IRS provides statistics is
2004.) More details in the table below.
5. Earn too much... or too little
Statistically, you have a higher chance of getting audited if you
were a high-income earner. About one in every 16 millionaires (those
who earned $1 million or more for the year) was audited last year.
The IRS also audited more than 257,000 filers who earned $100,000 or
more, more than double the audits of that income group in 2001.
But there's one blip in that pattern. Claiming the earned income
credit — a tax break for low-income individuals — can be an audit
red flag, says Tyson. The income requirements for the earned income
credit are very stringent. You qualify if you have one child and
your adjusted gross income was less than $32,001 in 2006 ($34,001 if
you are married, filing jointly) or if you have more than one child
and earned less than $36,348 ($38,348 if married, filing jointly).
If you don't have children, your adjusted gross income needs to be
less than $12,120 (or $14,120 if married, filing jointly).
It's a tax break that can provide much-needed cash to those who need
it. This year, for example, the credit can go as high as $4,536 for
filers with more than one child. The problem is that the rules for
claiming the deduction are complicated and prone to errors, says
J.K. Lasser's LeValley. To make matters worse, she adds, there are
dishonest tax preparers out there who claim the deduction
fraudulently, often without the tax filer's knowledge. As a result,
the IRS may flag a return that claims the earned income credit.
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