The IRS states in Publication 556 that it uses a computer program called the Discriminant Inventory Function System (DIF) IRS assigns a numeric value to each tax return known as a DIF score. Returns with a DIF score higher than a pre-specified number are flagged and sent to IRS regional examiners for further review and analysis.
The IRS examiners are trained to look for tax return items that indicate a high probability of error or fraud.
These items are known in the industry as “red flags.”
The 5 major red flags IRS examiners look for are discussed separately below.
Home Office Deduction
For most people expenses incurred in maintaining a home are non-deductible personal expenses.
However, if you use a portion of your home for business, you are entitled to deduct the costs related to that portion as a Home Office Deduction.
A Home Office Deductions (HOD) is a red flag because the IRS has determined that many taxpayers (and unscrupulous preparers) have historically used the HOD as a means of converting otherwise non-deductible personal expenses into deductible business expenses.
Thus, IRS examiners will carefully scrutinize all tax returns in which a home office deduction has been claimed.
All other things being equal, your chances of being audited are greater if you claim a HOD than if you don’t claim one.
If you work for someone else and receive an annual Form W-2 showing the amount of wages you received with taxes withheld from your wages during the year, you are entitled to take a deduction for expenditures you made during the year in connection with the performance of your job only if the following three conditions are met,
- the total of all such expenses exceed 2% of your Adjusted Gross Income (AGI);
- the expenditures were “ordinary and necessary;” and
- the expenses were not reimbursed or reimbursable by your employer.
Some taxpayers – usually traveling salesmen and commission based employees – will claim as a deduction various outlays that are not reimbursed by their employer.
The IRS starts with the assumption that if an employer doesn’t reimburse a specific expenditure made by the employee in the conduct of his or her work, that expenditure is probably not a true job expense and, therefore, so minus any additional proof is probably not deductible.
Consequently, the mere existence of a Job Expense will cause an IRS regional examiner to more carefully scrutinize a taxpayer’s tax return.
This, of course, means that a tax return containing a Job Expense deduction is more likely to be audited than one that does not contain the deduction..
Rental losses are subject to a number of complex rules of which even seasoned taxpayers sometimes run afoul.
The rental activities of most taxpayers will be considered passive and, therefore, the rental expenses associated with these activities will be deductible only to the extent of the rental income generated by them.
Taxpayers with passive rental losses who meet certain conditions are permitted to deduct up to $25,000 of excess rental losses. The $25,000 passive loss allowance is phased out for taxpayers with modified AGI exceeding a specified amount (roughly $150,000).
Some taxpayers by virtue of the time they spend managing and running their rental operations (the time spent is called “material participation“) will be considered to be in the business of renting real property (as opposed to passively renting real property) and these Real Estate Professionals are entitled to deduct their rental property losses in full.
In order to determine whether or not a particular taxpayer is in fact a material participant in his rental operations, the IRS requires the taxpayer to have spent a specified number of hours during the year in activities related to the management and operation of the rental property.
IRS regional examiners are trained to scrutinize tax returns in which taxpayers are claiming rental loss deductions greater than the passive loss allowance.
If a taxpayer is a full time employee or is self-employed, the IRS deems it unlikely that he or she will have had the available time to materially participate in a particular rental activity.
Consequently, these taxpayers should expect their tax returns to be highly scrutinized to evaluate if an Audit is necessary.
Schedule C Expenses
Another area of historic abuse is the claiming by taxpayers of business deductions in excess of business income.
Taxpayers use Form 1040, Schedule C to do this.
If you are running a legitimate business and have a reasonable expectation of turning a profit, you may deduct the ordinary and necessary business expenses you incur in connection with operating that business.
Taxpayers who are employed by others (i.e. who receive a W-2 at year end) and who also claim a loss from a Schedule C business operation are likely to find their tax returns scrutinized to evaluate if an Audit is necessary by the IRS.
Because there is so much abuse in the Schedule C loss area, I adamantly recommended that taxpayers who are conducting for-profit business incorporate that business or form an LLC.
The reporting of businesses operations on Schedule C rather than a separate corporate tax return increases a taxpayer’s chances of being audited 50 fold.
This deduction has been historically abused by taxpayers because of two reasons:
- The documentation requirements have been lenient; and
- Taxpayers are entitled to claim a deduction for the fair market value of property they donate.
The IRS will scrutinize returns that include disproportionately large charitable contribution deductions.
First, each of these items requires a subjective judgment to determine whether and to what extent a deduction is permitted. The more subjectivity involved, the greater the likelihood of mistake or outright abuse.
Second, these deductions tempt taxpayers and unscrupulous tax preparers to try to convert personal, non-deductible living expenses into deductible expenses.
If you have legitimate home office expenses, job expenses, currently deductible rental losses, Schedule C losses and/or charitable contributions, you should consider:
- Are there are other items on your current year tax return or the last 2 years tax returns that you don’t want the IRS to scrutinize?
- What is the comparative value of the deduction?
- Weigh the benefit of the deduction against the costs (monetary and psychological) that would be involved should it trigger an audit.
If you are taking any these deductions, there are several things you can do to dilute their red flag status.
- Timely file your return;
- Use a recognized software program to prepare and print your return;
- File the return electronically;
- Have a respectable Enrolled Agent, tax lawyer or CPA sign your return as tax preparer; and
- Attach explanatory statements to your return where necessary.