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Top 5 IRS Audit Red Flags for Entrepreneurs!

Queen Tax & Financial Services

4 min read

Jan 9, 2023

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There is nothing more dreaded in the tax community, among taxpayers and tax preparers alike, than an audit. While the IRS does randomly select a number of tax returns to put its eyes on every year, your chances of being selected can increase significantly depending on various factors including the complexity of your return, the types and amounts of deductions or other tax breaks you claim, whether you're engaged in a business, or whether you have foreign income and/or assets. Math errors could also result in an audit, but they usually don't lead to a full-blown exam. The good news is that the IRS audit rate over the past few years has been less than 1% on individual returns and majority of those were resolved via mail. So while there's no sure way to predict an IRS audit, these 5 red flags could definitely increase your chances of drawing unwanted attention from the IRS.

 

1 - Not reporting all income.


The IRS gets a copy of all the 1099s you receive including independent contractor and investment income. Their super computers cross check the information on your return with all of the information submitted to them under your social security number for that particular tax year. While its perfectly acceptable to report additional income that they may not have known about, they usually notice when you underreport. This sends up a red flag and causes the IRS computers to generate a bill that you would either need to pay or amend your return to include it. This is also why you must report all income in the year it is received.

 

2 - Rental losses.


The passive loss rules usually prevent the deduction of rental real estate losses, but there are two important exceptions. First, if you actively participate in the renting of your property, you can deduct up to $25,000 of loss against your other income. The second exception applies to real estate professionals who spend more than 50% of their working hours and over 750 hours each year materially participating in real estate as developers, brokers, landlords, and the like. They can write off rental losses. Well, the IRS actively scrutinizes large rental real estate losses, especially those written off by taxpayers claiming to be real estate pros. It's pulling returns of individuals who claim they are real estate professionals but whose W-2 forms or other non-real-estate Schedule C businesses show lots of income. Agents are checking to see whether these filers worked the necessary hours, especially in cases of landlords whose day jobs are not in the real estate business.

 

3 - Not filing.


As explained above, the IRS is fully aware of most of the income you’ve received. So when they perform their annual internal audits, the missing return is likely to be exposed. While this happens at every income level, the primary emphasis is on individuals who received income in excess of $100,000 but didn't file a return. Collections officers will contact taxpayers and work with them to help resolve the issue and bring them into compliance, which can often include a manual review of the return you submit and possibly an audit of previous or future returns as well. People who refuse to comply can be subject to levies, liens, and even criminal charges.

 

4 - Day trading losses.


People who trade in securities or the foreign exchange market have significant tax advantages over any other type of investor. The expenses of traders are fully deductible and are reported on Schedule C, while the expenses of investors are nondeductible, and traders' profits are exempt from self-employment tax. Plus the losses of traders who make a special election are deductible and are treated as ordinary losses that aren't subject to the $3,000 cap on capital losses, among other tax benefits. But to qualify as a trader, you must buy and sell frequently and look to make money on short-term swings in prices. The trading activities must also be continuous over the full year, not just a few months. This is different from an investor, who profits mainly on long-term appreciation and dividends, holds their securities for longer periods, and sell much less often than traders. The IRS knows that many filers who report trading losses or expenses are investors. They often pull returns and check to see that the taxpayer meets all the rules to qualify as a “real” trader.

 

5 - Cash transactions.


The IRS gets many reports of all cash transactions over $10,000 from banks, casinos, car dealers, pawn shops, jewelry stores and other businesses, plus suspicious-activity reports from banks and disclosures of foreign accounts. If you make large cash purchases or deposits, be prepared for IRS scrutiny. Also, be aware that banks and other institutions file reports on suspicious activities that appear to be trying to avoid the currency transaction rules (such as a person depositing $9,500 in cash one day and an additional $9,500 in cash two days later).

 

Bonus - Crypto.


The IRS is on the hunt for taxpayers who buy, sell, receive, trade or otherwise deal in bitcoin or other virtual currency and is using pretty much everything in its arsenal. As part of the IRS's efforts to clamp down on unreported income from these transactions, revenue agents are mailing letters to people they believe have virtual currency accounts. The agency went to federal court to get names of customers of Coinbase the IRS has set up teams of agents to work on cryptocurrency-related audits. Additionally, all individual filers must now state on page 1 of their Form 1040 whether they received, sold, exchanged, or disposed any financial interest in virtual currency during the year. They are cross-checking returns to ensure that tax is collected on capital gains from these transactions.

As you can see, these are all activities that could be normal for a business or entrepreneur. That’s why it is crucial to that you work with a tax professional who is educated and knowledgeable in these areas, and who is experienced with your situation. Schedule a free consultation to discuss your individual tax situation and how we can help you achieve your goals!

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