8 Invitations to an IRS Tax Audit

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

Advertiser Disclosure ▾

This page contains affiliate links from which we receive a compensation. Like many publications Wise Bread is supported by affiliate commission from partner companies whose products appear on our site. This may influence which products we write about and the location and order in which products appear. We aren't able to cover every product in the marketplace.

Wise Bread Picks

• Travel Rewards Credit Cards
• Cash Back Credit Cards
• 0% Balance Transfer Credit Cards

If you aren’t thinking about a tax audit, you should be. They can be a nightmare even if you’re completely honest.

Thanks to the staggering federal deficit, the IRS is trying to close the $300 billion gap between what Americans pay in taxes and what the government thinks we should have paid. You aren’t paranoid if someone is really out get you, as the saying goes, and the IRS is out to get you.

Consider this recent IRS job posting:

Internal Revenue Agent (Abusive Transactions Group)

Agents of the Abusive Transactions Group will be conducting examinations of individuals, sole proprietorships, small corporations, partnerships and fiduciaries.

This group specifically goes after taxpayers who generally have higher incomes than most taxpayers, need to file more tax forms, and generally need to rely more on paid tax preparers.

But even if you aren’t wealthy, don’t operate a cash business, and you don’t have a CPA filing reams of forms for you, you still can easily become an IRS target.

Twice as many tax returns were audited in 2009 as 2000. Enforcement revenue over the same period was up 50%.

It’s important to note that in this land of equality, not all individuals or companies are treated equally when it comes their chances of an audit. About one in a hundred businesses with less than $10 million in assets is audited. That number jumps to 10 in a hundred for those with $10-$50 million in assets, and 1 in 4 for businesses with assets greater than $250 million.

Certain industries are scrutinized more heavily too. You can probably guess some of them — cash businesses are always high on the IRS hit list. But would you suspect Dr. Doggie, the vet, is a target too? It turns out the IRS has a special auditor guidebooks for veterinarians, and for ministers, laundromats, car dealers, and many others too. Their Retailer Guide offers specific strategies for interrogating e-commerce businesses, gas stations, direct sellers, mobile food vendors, pizza shops, and the like.

You can read all about how auditors are instructed to look for tax cheats in these publicly available guides. They’re not easy reading like a John Grisholm novel, but they will make the hair on your neck stand on end. Here are some "red flags" that commonly trigger an audit.

1. Math Errors

While an error in basic math might not instigate a full blown line-item audit, it’s the most common reason Americans receive those heart-attack inducing letters from their friendly local IRS office. Use a calculator and check your numbers twice.

2. Unusually High Itemized Deductions

The IRS uses a very secret formula to calculate what your deductions should be. If computer scan of your returns shows that your deductions for charity, travel and entertainment, and healthcare are out of line with your income, you’ll be on their radar.

3. Self-Employed/Schedule C Filers

Small businesses are suspected of being especially creative with their expenses. Be careful if you take a home office deduction, have lost money for several years in a row, and prepare your returns yourself rather than use an accountant. 

4. Lots of 1099s

In February of 2010, in hopes of adding billions to depleted U.S. Treasury coffers, the IRS began a three-year initiative to crack down on what they believe to be a common practice of misclassifying employees as contractors.

Six thousand businesses have already been targeted for audit, and the government hopes to hire 100 new Department of Labor employees specifically to police these abuses. And yes, the do share their successes with the IRS and State authorities.

5. Unreported Income

Be especially careful to report all your income. If you’ve received a 1099, so has the IRS and their computers will notice if they don’t match up.

The same is true for other sources of income. If your former spouse reports alimony paid and you don’t report receiving it, you’ve just painted a big bull’s-eye on your tax return.

6. Previously Audited

If you’ve been audited in the past don’t think you’re off the hook — especially if you owed taxes or fines. The IRS knows people have the mistaken impression that the auditor won’t come knocking twice. But, of course, just the opposite is true.

7. Shareholder

If you are an investor in a partnership or corporation that came under the gimlet eye of the Feds, you may be next in line.

8. Pissed Someone Off

Disgruntled former employees are a regular source of IRS tips. But payback isn’t the only reason people go the IRS — the agency is authorized by law to pay rewards to informants. In cases that involve huge amounts of money, the informant’s cut can be as high as 30% of what they collect.

Make no mistake, your IRS auditor won’t be jolly.