Thursday, March 21, 2013

12 tax audit red flags


To avoid catching the attention of the IRS, beware of these tax audit red flags. 


You have foreign assets

You have foreign assets

Stashing money overseas? Then you're probably well aware that the IRS has been ramping up its efforts to rein in offshore accounts.

Launched in 2009, the agency's voluntary disclosure program has already raked in more than $5 billion in back taxes, interest and penalties from tax cheats for illegally hiding assets in offshore accounts.

Taxpayers are asked to check a box on Schedule B if they have an ownership interest in foreign accounts. If they then fail to provide information about those assets, it will undoubtedly trigger an audit, said Mark Luscombe, principal analyst at tax research firm CCH.

Indicating on your return that you do business in foreign countries or take many trips abroad for work could also raise eyebrows if no foreign assets are reported.

And the penalties for hiding offshore accounts are huge, including a fine of $100,000 or 50% of the balance -- whichever amount is greater -- for accounts that are willfully undisclosed. 

Your ex wants revenge 

Following messy divorces, many ex-spouses will go to great lengths to get revenge -- some will have even try to wreak havoc on your reputation by contacting the IRS.

John Lieberman, a CPA at Perelson Weiner LLP, said he has heard of people telling the IRS that their ex-spouse laundered money, committed serious financial crimes, underreported income, even owned a brothel.

"[Ex]-spouses love writing letters to the IRS," said Lieberman.

It's not just the ex-wife or husband you have to watch out for. Lieberman said he worked on one case where the mother-in-law told the IRS that her ex-son-in-law was a money launderer.

Sometimes the claims are completely made up, while others are legitimate. And while some people write in anonymously, others divulge their names -- which is required in order to claim a whistleblower reward of 15% to 30% of any extra money collected as a result of their tip.

Your return has too many zeroes

While rounding numbers on your tax return to the nearest dollar is okay, rounding to the nearest thousand is not -- especially when itemizing deductions like business expenses, unreimbursed employee expenses and job hunting costs.

If you submit figures like $5,000 in auto costs, $2,000 in gas mileage and $4,000 in lodging, it may look like you pulled those numbers out of thin air or inflated them by rounding -- since it's unlikely that every single expense was a perfect multiple of $1,000.

"Having a return with a lot of zeroes on it may be a cause for a return to be pulled," said Lieberman. 

You have a home office

Just because you do some work on your couch while watching TV doesn't mean it counts as a home office.
After years of watching people abuse the home-office deduction, the IRS is on the look-out. In order to avoid being scrutinized, make sure you only claim reasonable expenses -- and only those that directly apply to the part of the home used as an office.

Remember: The credit can only be claimed if the home office is your primary place of business and is used exclusively for work. People get into trouble when the IRS suspects they are mixing personal costs with their business costs.

But if you have a legitimate home office, don't be afraid to claim it.

"Taxpayers entitled to these deductions should still claim them -- just be sure to have documentation to support the claimed expenses, avoid understating income and understand and comply with the home office requirements," said Luscombe.

You forgot some income

For people who earn money from various places, remembering to report every single cent can be difficult. But 'I forgot' isn't a good enough excuse for the IRS.

For any miscellaneous income over $600 you received throughout the year, the company you worked for should send you a Form 1099. If you don't receive it for some reason -- it was mistakenly sent to a previous address, for instance -- you can be sure that the IRS will still get it.

You can either request the missing form from the employer or simply report the income without the form. This is why it helps to track your income throughout the year.

Of course, some people earn money that may not get reported on 1099s -- like side money made giving people haircuts. Even if the IRS doesn't know about it, you must report this income as well or you risk the agency finding out and nailing you for tax evasion.

"Some people have a tendency to forget when they got a few checks here and there, but for some people it's willful," said Lieberman.

You claim fishy deductions

Sometimes claiming a tax deduction you know is a stretch just isn't worth the risk of an audit.
One of the most common gambles: Writing off a swimming pool for medical reasons, said John Lieberman, CPA at Perelson Weiner LLP.

"Just because your back hurts doesn't make your pool deductible," he said.

To qualify, you must be able to prove that you purchased the pool solely to help with the treatment of a verifiable medical condition and this remains its primary purpose. If you don't have a doctor's prescription requiring the use of a pool or if you have easy access to a public pool, the deduction likely won't be allowed and it may lead the IRS to take another look at the rest of your return as well.

A Playboy magazine subscription for a doctor's office, a hip replacement for a dog and pole dancing classes are some other bizarre tax write-offs people have unsuccessfully tried to claim. That said, crazy attempts can occasionally pay off. One taxpayer successfully deducted the cost of caring for the carrier pigeon that he used to communicate with his business partner. 

You're rich

Not only do high-income taxpayers have more complicated returns, but they bring in much more revenue for the IRS with each mistake they make.

While only 1% of the overall population gets audited, the odds jump to 21% for taxpayers with income over $5 million and to 30% for those earning $10 million or more, according to the most recent statistics from the IRS.

"It's not that higher income taxpayers cheat more, it's just that you have a lot more going on on a high-income return," said Betsey Buckingham, an enrolled agent at accounting firm David C. Murray & Company. "Most of the high-income people I've [assisted] are involved in charities or very active in their own business."

Even if you're not rich but live in a wealthy neighborhood, your return could raise questions about how you can afford to live there -- especially if you report surprisingly low income or a big business loss.

"They notice if you don't have an income that closely matches the kind of lifestyle you live," said Buckingham.

You say the wrong things

Watch what you say and who you say it to. Even if you're joking, you never know when a friend or neighbor will decide to rat on you. Talking with the press about personal or business information or making a public statement that doesn't match the information you provide to the IRS can also get you in trouble.

If a newspaper publishes a profile of your business in which you gloat about surging profits but you then post big losses on your tax returns, the IRS may start digging into your file.

Celebrities have to be extra cautious. The New York State Department of Taxation went after baseball player Derek Jeter for state income tax, citing public statements he made "professing his love for New York" as part of its argument, according to legal documents from the state agency. That gave the agency enough of a reason to allege the baseball star was a resident of New York (not Florida, as he claimed), said Lieberman.

"Be careful what you say, if even an athlete who says his heart is in New York can all of a sudden get a New York State tax audit," said Lieberman.

You do a lot of 'work-related' driving

With gas prices so high, who wouldn't want to write off all of their driving costs? But unfortunately, you can only deduct gas costs if the driving you did was for business purposes.

Buckingham had a client who owned a catering company and claimed every single trip to the grocery store as a business expense, even when some of those trips were to pick up her own groceries. Those driving costs really added up -- to the point where they created a loss for the business (on paper) since it was making so little income.

So Buckingham and the client had to go through the grocery receipts and separate the personal shopping from the business shopping and claim the gas costs accordingly.

You exaggerate donations

Even good deeds can spark suspicion at the IRS.

If you report extremely high charitable contributions -- especially relative to your income -- make sure you have the proof to back it up.

Receipts for cash donations of more than $250 are required in the event the IRS comes knocking.
Cash donations are a little trickier, because it's common for people to think the items they donate are worth a lot more than someone will actually pay for it. So it's important to be reasonable with your valuations.

"Unless it's something brand new and still has tags, there's some reduction in price," said Buckingham.
Goodwill and Salvation Army even have lists that help you assign values to certain items when donating them. If you donate something bigger, like a car or a boat, the charity will give you a receipt stating the ultimate auction or sale price, she said.

You own a money-losing business

If you own a business that is reporting losses year after year, the IRS may grow suspicious that it's actually a hobby.

"There's a rule-of-thumb saying you must have a profit in two [out] of five years -- if you don't have a profit they're going to look at it as a hobby," said Buckingham. "You can rebut that presumption by showing that maybe what you're doing is increasing the value of assets but not necessarily the profit."

One example is a business like a garden nursery, where you have to spend a lot of money growing trees and plants but won't get a real return on that investment until they are grown, she said.

To fend off the IRS, make sure to keep diligent financial records and do little things like have business cards and company letterhead.

Sometimes, though, it's beyond your control. One of Buckingham's clients, an ice cream store owner, was audited two years in a row after reporting losses for both years. The IRS agent said the agency couldn't figure out how the client was living day-to-day if her primary business was losing so much money.

What they didn't realize was that she had refinanced her mortgage and was living off of that. Both audits resulted in no changes to her refunds, and the audits then stopped.

You have a shady tax preparer

If your tax preparer tries to convince you to claim deductions that sound too good to be true or to report income that doesn't line up with what you would have reported, watch out.

You want a preparer that will get you the best refund possible -- but not if it means breaking the law.
You should also be suspicious if the preparer doesn't ask for documentation like receipts or for expenses or deductions you're claiming.

For example, if they write down their own value for the bag of clothes you told them you gave to Goodwill or estimate that you spent $2,000 on home office furniture without going through everything with you, that's a bad sign.

"A preparer's job is not to suggest a deduction," said Buckingham. "Certainly if [the taxpayer] had a deduction last year, a preparer should ask whether they are still doing this activity, but if a taxpayer says they are, the preparer needs to ask for something that would substantiate it."

The IRS also recommends avoiding tax preparers who calculate their fees as a portion of a taxpayer's refund or promise taxpayers unattainable refunds.

For more about audits, check out this article:

What Triggers an IRS Audit?

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