Audit Red Flags: What Raises Eyebrows at the IRS?

Are you worried about being audited? The fear may be overblown – according to Internal Revenue Service data, only 1% of taxpayers had their federal returns examined in 2012. Last year, 12.1% of millionaires had their returns scrutinized, down from 12.5% in 2011. The agency reviewed only 0.6% of returns sent in by taxpayers making between $50-100,000.

Still, no one likes extra stress courtesy of the IRS. Self-employed individuals seem to be magnets for audits – in fact, IRS data indicates that people who work for themselves and earn from $100,000-$200,000 a year are five times more likely to get a second look from the agency than the typical employee.

Let’s look at some red flags that might get you extra IRS scrutiny. (We’ll end on a positive note – you or someone you know might be eligible for an unexpected federal tax refund from 2009.)

A Schedule C that hints at some odd bookkeeping. Schedule Cs get a close look annually as the IRS seeks to remedy the tax gap (the difference between federal taxes owed and federal taxes paid). As Schedule Cs are often filled out by solopreneurs and small business owners themselves, the chances increase for claiming substantial deductions that may be hard to substantiate.

Taxable income of $1 million or more. Millionaires work with accountants for a reason – generally speaking, returns prepared by tax professionals raise far fewer red flags than DIY ones. If you will make around $1 million this year, look back at the first paragraph of this article and consider whether or not it might be wise to defer some potentially taxable income into 2014.

Bad math. The IRS does spot mediocre mathematics in returns. It has even recalculated taxes to save people money in years when special tax credits were available, such as the Making Work Pay Credit in 2011. However, it also finds unreported and underreported taxable income through the same scrutiny.

Errors are down: the IRS says taxpayers and preparers made 2.7 million math mistakes on their 2011 federal returns last year, improved from 6.6 million errors the year before. Still, that’s a lot of mistakes. In 2012, miscalculations of tax owed represented 24% of the errors; misreported exemptions accounted for another 15%, and faulty claims to the Earned Income Tax Credit accounted for 13% more.

Huge deductions. Is your money-losing small business venture truthfully just a hobby? Did you really donate $6,000 worth of office supplies to a charity, and do you have the receipts to back that up? The IRS routinely checks returns for deductions that seem outlandish.

Living large. Does the IRS peruse social media? Yes it does, as we all do. The IRS has done good detective work for years; its investigators know to check out DMV and employment records to get a better picture of an errant taxpayer. Today, photos and posts on Facebook, MySpace and Twitter can telegraph potentially valuable nuggets of information, particularly about young taxpayers who have come into wealth that their returns don’t seem to show.

If you’re reading this, you’re paying more attention than many others. That claim really isn’t so grandiose – a staggering number of Americans procrastinate on their federal taxes. Last year, Capital One Bank’s Taxes and Savings Survey found that 11% of taxpayers intended to file at the last minute. For that matter, about 5% of Americans (7 million people) don’t file federal returns at all – and it isn’t necessarily because they don’t earn enough taxable income.

P.S.: you or someone you know might be eligible for some money. The IRS has $917 million in unclaimed refunds waiting for taxpayers who didn’t send in federal returns for the year 2009. The IRS estimates that half of these unclaimed refunds are greater than $500. Visit irs.gov if you think you are eligible. If you are, you must file a 2009 federal return (and put it in the mail) ASAP – the postmark deadline is Monday, April 15, 2013.