Red Flags For IRS Audits

Here we are in the middle of tax filing season, and we all want to make sure we get the biggest refund possible, or at least owe as little to Uncle Sam as we can legally get away with, right?  If you are doing your own taxes using one of the software programs out there, good luck to you.  I hope you don’t miss anything!  If you really want to make sure your taxes are done right, that you are fully compliant and that your returns will be the most accurately done as they can be done, go to an Enrolled Agent for your tax preparation.  The following red flags should be well known by a tax professional, especially one of America’s Tax Experts, an Enrolled Agent.

For those of you that choose to go it alone, there are some areas that are at the top of the list for being audited by the IRS that you should be aware of so that you don’t fall into any traps.  The top five that are scrutinized are:

  1. Charitable Donation Deductions – These are a great write off on your personal taxes if you itemize.  However, if they are considered by the IRS to be excessively large, particularly in comparison to your income level, it could raise that red flag and trigger an audit.  It is critical that you have documentation to substantiate these.  Gifts by cash typically require you to have copies of checks, a receipt from the 501(c)(3) that you contributed to at the very least.  If a non-cash contribution is over $500 you absolutely have to have an appraisal or some other form of documentation proving the value of the donation.
  2. Business Use of a Vehicle – This one seems like an “easy money” deduction on a tax return, right?  Not so much!  You again have to be able to substantiate the deduction.  A mileage log is a critical piece of the puzzle on this one.  If you do not have a detailed mileage log, showing the business purpose, beginning and ending mileage – for each trip – and dates of the trips, you can pretty well count on an IRS Revenue Agent to disallow the deduction.
  3. Business Meals, Travel and Entertainment – If you have large deductions for meals and entertainment, especially if it is out of line for your business or profession, it can trigger an audit.  You have to be able to substantiate the business purpose for the expense.  This means that you need to keep detailed records for these expenses including the purpose of the meeting, the place of the meeting, the people involved in the meeting and what business issues were discussed.  To take it one step further, if the expenditure is $75 or more you had better have a copy of the receipt or it will get tossed in an audit.
  4. Rental Real Estate Losses – This is a bit of a tricky one.  If you buy a property as an investment and you rent it out, you should be able to write off any losses that you incur, right?  The IRS say not so fast.  There are some rules you have to follow.  First of all, passive loss rules prevent you from deducting the losses on your tax return.  Passive loses can be defined by “participation” in the rental process.  If you are a Real Estate professional that spends at least half of your time participating in Real Estate Development, Broker, Landlord or other related activity, then you can write off the losses without any limitation.  If you own a rental property and actively participate in the rental of your property, then you have the right to deduct up to $25,000 in losses as long as your Adjusted Gross Income doesn’t exceed $100,000.  If your AGI is between $100,000 and $150,000 there is a phase out of what you can deduct.  If you have an AGI in excess of $150,000 bye bye write off!
  5. Small Businesses – A self employed person that reports that income on a Schedule C is, unfortunately, at a bigger risk simply because they report their income on Schedule C.  An IRS Revenue Agent knows from experience that this is a possible gold mine for them.  Many of those that are self employed either under-report their income or over-inflate their expenses in order to pay lower taxes.  It is even worse if you are in a business that they consider to be a “cash-intensive” business.  They are also beginning to take a closer look at the smaller S Corporations, and LLCs .

The bottom line to all of this is simple:  Keep good records, do things honestly and ethically, and if you do get that nasty audit notice in the mail, contact an Enrolled Agent to help you.  They are not only great at the initial tax preparation, they are experts in Tax Representation and can help you through your situation all the way up to Tax Court.

Audit Risk

The last thing anyone wants to see in their mailbox is a letter from the IRS telling them that their tax return is under examination.  This is how the folks at the IRS tries to soften the blow of telling someone that they are being audited.  If you were to ask a Revenue Agent why one return is selected for audit and another one isn’t they would tell you that returns are picked for examination at random.  But are they really?

The answer to that question is hard to determine.  Each tax return is scored using “a mathematical technique used to score income tax returns for examination potential” which is called a Discriminatory Index Function (DIF) score.  Of course, the IRS will not reveal the actual method they use to come up with the DIF score.  There are some very likely triggers, some of which are:

• Comparing income level with the average income in a specific zip code or area.
• Comparing the taxpayer’s return to other returns with their occupational classification
• Matching income on the return with those from Third Party reporters on  W-2 and 1099 forms.
• Returns with Schedule C income, because the IRS has determined that there tend to be more mistakes on this Schedule.


There are also some definite red flags that may result in audits.  These include:

• Taking significantly higher than “usual” itemized deductions
• Excessively large charitable contributions
• Losses incurred from rental property and how they are claimed. In other words, you cannot claim a loss for a rental property as a real estate professional unless you actually are one.
• Alimony deduction – does the payer and payee have matching amounts on their returns?
• “Hobby Loss” can be an issue. Typically, if a business is reported on a return and it shows a loss in three of the last five years, the deduction for the loss may be disallowed because it is considered to be a hobby, not a real business.
• Meals, travel and entertainment deductions that are extremely high can be an red flag.
• 100% business use of a vehicle, particularly if the vehicle is the only one available to the taxpayer can be a problem.
• A deduction for a home office (other than using the simplified option) is a red flag. You actually need to have a designated office used only for that purpose.

The bottom line is this – if you have anything that you are deducting from your taxable income, make sure that you can substantiate it.  That way, even if you do get one of those wonderful letters in the mail, you can prove that the deduction was legitimate.

Tax Preparation fees with no surprises!

TurboTax seems to be the “go to” software for those who want to do their own taxes.  Seems like Intuit decided to take advantage of their customers by raising their prices without saying anything to their long time customer.  While Intuit and TurboTax are trying to fix the problem they created by their decision charge extra for some of the standard tax return schedules – Schedules C, D and E to be exact – those who use CFO Business and Tax Services, Inc. for their tax prep know two important things.  First, we have standard fees that are listed conveniently on our website.  Second, our clients know that we will always treat them with respect and do our absolute best to make sure they pay no more in taxes than they have to.  Oh, and they also know that if they refer three new clients to us who have their taxes prepared at CFO Business and Tax Services, their returns are done for FREE!!!

2015 Tax Season

Tax season is upon us once again!  Just wanted to let you all know that as 2015 begins the IRS has indicated that they will begin accepting returns on January 20th, both electronically and by paper.  With this being the first year involving the Affordable Care Act information, it is more important than ever for you to seek the help of a professional in filing your taxes.  It is our hope that you will choose CFO Business and Tax Services as your preparer!

Expiring Tax Deductions

While many of the usual temporary tax deductions and credits were made permanent in 2012, there’s still a large number that weren’t, and that are currently slated to expire or change significantly at the end of the year.

All of the items in this section expire December 31, 2013.

Educator’s Expenses, IRC Sec. 62(a)(D)

What it is now: Grades K–12 teachers, instructors, counselors, principals and aides can deduct up to $250 of out-of-pocket costs above the line.

Cancellation of Debt — Mortgage Debt, IRC Sec. 108(a)(1)(E)

What it is now: Individuals can exclude up to $2 million ($1 million for married filing separately) of COD income from qualified principal residence indebtedness that is canceled because of their financial condition or decline in value of the residence.

Mortgage Insurance Premiums Deduction, IRC Sec. 163(h)(3)

What it is now: Taxpayers with AGI no greater than $109,000 can treat qualified mortgage insurance premiums as home mortgage interest.

Personal Energy Property Credit, IRC Sec. 25C

What it is now: A credit (subject to a $500 lifetime cap) is available for qualified energy efficiency improvements and expenditures to a taxpayer’s principal residence.

State and Local Sales Taxes Deduction, IRC Sec. 164(b)(5)

What it is now: Individuals can elect to deduct state and local general sales taxes instead of state and local income taxes.

Tuition and Fees Deduction, IRC Sec. 222

What it is now: Individuals can claim an above-the-line deduction for tuition and fees for qualified higher education expenses.

 All of the following have major changes at the end of 2013 as well.

Qualified Conservation Contributions, IRC Sec. 170(b)(1)(E)(vi), 170(b)(2)(B)(iii)

What it is now: The deduction limit for qualified conservation contributions by individuals is increased from 30% of AGI to 50% of AGI (100% of AGI for qualified farmers and ranchers) and the carry-forward period for qualified contributions in excess of the AGI limit is 15 years.

What happens in 2014: No special rules for qualified conservation contributions, so they are subject to the 30%-of-AGI limit and have a five-year carry-forward period.

Qualified Small Business Stock Gain Exclusion, IRC Sec. 1202(a)(4)

What it is now: QSBS acquired Sept. 28, 2010–Dec. 31, 2013 qualifies for 100% gain exclusion (if the holding period is met). For stock acquired during that period, the following rules also apply: 1. None of the 60% gain exclusion rules for QSBS issued by a QBE apply. 2. No portion of the excluded gain is added back to determine alternative minimum taxable income.

What happens in 2014: Gains on QSBS acquired after Dec. 31, 2013, qualify for a 50% gain exclusion [60% for QSBS issued by a qualified business entity (QBE)]. Also, a percentage of the excluded gain is an AMT preference item.

Qualified Charitable Distributions, IRC Sec. 408(d)

What it is now: Taxpayers over age 70-1/2 can make tax-free transfers from an IRA directly to a charity. Any amounts so transferred count toward the individual’s required minimum distribution, but are not deductible as charitable contributions.

What happens in 2014: Income exclusion for QCDs expires on Dec. 31, 2013

Qualified Leasehold, Restaurant and Retail Improvement Property, IRC Sec. 168(e)(3)(E)

What it is now: Qualified leasehold improvements, qualified restaurant property and qualified retail improvements are assigned a 15-year (straight-line) recovery period.

What happens in 2014: All are assigned a 39-year (straight-line) recovery period.

Section 179 — Deduction Limit, IRC Sec. 179(b), (c) and (d)

What it is now: The Section 179 deduction and qualifying property limits are $500,000 and $2,000,000, respectively. In addition, off-the shelf computer software qualifies for Section 179 expensing and taxpayers can amend or irrevocably revoke a Section 179 election.

What happens in 2014: After 2013, the deduction and qualifying property limits are $25,000 and $200,000, respectively. Off-the-shelf software does not qualify for Section 179 expensing and the election generally is irrevocable with IRS consent.

Section 179—Qualified Real Property, IRC Sec. 179(f)

What it is now: Taxpayers can claim the Section 179 deduction on up to $250,000 of qualified real property (qualified leasehold improvements, qualified restaurant property and qualified retail improvement property).

What happens in 2014: Qualified real property is not eligible for Section 179 expensing.

Special (Bonus) Depreciation, IRC Sec. 168(k)

What it is now: 50% special depreciation is allowed for qualified property additions placed in service in 2013. (Note: For 2013, the Section 280F limit on depreciation for passenger autos is also increased by $8,000 for qualified property and no AMT adjustment applies to property for which the special depreciation allowance is claimed.)

What happens in 2014: Special deprecation only available for long production-period property and certain aircraft.

 There’s more!

Among the other provisions that are expiring are:

• The Differential Wage Payment Credit

• The tax credit for new energy-efficient homes

• The tax credit for 2- and 3-wheeled plug-in electric vehicles

• The research credit for the cost of increasing research activity

• The domestic producer deduction for Puerto Rican activities

And the provisions that are changing include:

• The tax credit for alternative fuel vehicle refueling property

• The Sec. 170(e)(3) donation of food inventory deduction

• The monthly exclusion for transit passes and vanpooling

• The Sec. 374(d)(7) S corp built-in gains provision

• The Sec. 1367(a)(2) S corp shareholder basis adjustment for charitable contributions provision