Of course, some things are simply obvious audit triggers such as reporting more expenses than income. However, there are other areas to which taxpayers may not be privy.
Carl Johnson is a self-employed certified public accountant who has operated an accounting and tax practice in New Orleans for more than 15 years. He has seen his share of audits and has closed approximately 90 percent of them with the IRS favorably agreeing with his positions.
"Understanding what triggers an audit is key," he says. "Factors such as losses from year to year, unusual and large questionable deductions, and third-party referrals are some of the biggest factors considered when the IRS determines whether a tax return should be audited."
If you earn income through self-employment or rental income, a red flag may be embedded in your return. Unlike wage earners, sole proprietors or landlords can report income and expenses at their discretion, especially in cases where individuals receive cash or unreported payments from clients or customers.
The IRS also reviews these returns to make certain that deductions are in line with the income reported on the tax return.
"Taxpayers who have excessive deductions, (or) unreasonable and questionable expenses are likely to trigger an audit," says Johnson.
Before preparing your tax return, question whether your expenses are reasonable and customary for your line of work. For example, does your company really need to pay excessive amounts in meals and entertainment costs for a dog-trainer business? Maybe. Maybe not. Either way, your tax return has to first pass the "smell test" to ensure your return is not the lucky lottery winner of an audit.
Johnson also says underreporting income is an instant audit trigger. The IRS ensures taxpayers' compliance through its Automated Underreporter Program. The program matches income reported on the federal income tax return to information obtained from third parties, such as employers and financial institutions. If there is a mismatch, you will receive a notice from the IRS informing you of an additional tax assessment.
Although the IRS is forthcoming about its automated underreporting program, know that penalties assessed can be waived. If you have been assessed penalties and can show reasonable cause, those penalties could be removed, thus lowering your overall tax liability.