Smart Tax Planning

Here are some red flags that could grab the attention of IRS

Key Points
  • There are inquiries from the IRS that fall short of an official audit.
  • In fiscal year 2019, fewer than than 0.5% of tax returns were audited.
  • Earning a lot of money isn't the only thing that can spark interest from the IRS.

Trying to pull a fast one on the taxman could come with regrets.

While the IRS is auditing fewer tax returns that it once did, the agency's systems are automated to spot certain discrepancies. And, there are some parts of returns that simply generate more scrutiny than others.

In other words, there is still a risk that you could hear from the IRS.

"A lot of this is done by analytics and computers and the farther you are from the normal range for similar taxpayers, the more likely you are to get a love letter in the mail from the IRS," said certified financial planner Jeffrey Levine, director of advanced planning at Buckingham Wealth Partners.

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The IRS will handle an estimated 150 million returns this filing season, with the filing deadline set for July 15. As of June 12, the agency had received more than 136.5 million returns and issued 92 million refunds. The average refund is $2,767.

While most people will never face an audit — only 0.45% were audited in fiscal year 2019 — there are other types of IRS inquiries, such as a notice of income-reporting discrepancy and proposed additional tax due. Those communications fall short of an official audit, which the IRS gets three years to initiate after the challenged return is filed.

The biggest item that lands you most at risk for an audit is making a lot of money: If your income is between $1 million and $5 million, the audit rate jumps to 2.21%. For returns with $10 million or more, it's 6.66%.

However, even if your income is lower, don't assume you won't generate attention — income isn't the only consideration. And for all you work-at-homers, keep in mind that only self-employed taxpayers can deduct unreimbursed job expenses. If you're a full-time employee, forget it.

Here are some other common things that could prompt the IRS to look more closely at your 2019 return.

Unreported income

One consistent thing that will spark IRS attention is a discrepancy between your reported income and the information the agency has.

Remember, all those forms you receive showing income — i.e., your W-2 from work, a 1099-MISC or 1099-K reporting side income or 1099-INT showing taxable interest of $10 or more on a bank account — also go to the IRS.

And if you fail to report any of those earnings, you'll hear from the agency — the discrepancy will generate an automatic letter.

"It can be hard to keep track of all the forms if you have income from a variety of sources, but the IRS does a good job of matching them [to your reported income]," said CPA Sarah Shannonhouse, a manager in the tax practice & ethics section for the American Institute of CPAs.

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Even if you don't receive an official income form for work you performed, you probably still need to let the IRS know about it. If the income (after expenses) from, say, a side gig is at least $400, you'll have to pay self-employment taxes on it.

And for the cryptocurrency investors out there: Don't forget you should be reporting your gains (and losses) on bitcoin and its brethren. The IRS has been beefing up its enforcement efforts and cracking down on scofflaws.

And new for this filing season is a question on one form (Schedule 1) that requires you to disclose if you engaged in any virtual currency transactions in 2019.

Earned income tax credit

This credit is generally available to working taxpayers with children, as long as they meet income limits and other requirements. Some low earners with no kids also may be eligible for it.

Because it's refundable — meaning it could result in a refund even if your tax bill is zero — it's considered valuable to working parents with low or modest income.

However, it's also been an area that some taxpayers have abused.

"There are bona fide instances for qualifying for the earned income tax credit," said Kathryn Hauer, a certified financial planner with Wilson David Investment Advisors in Aiken, South Carolina. "But the IRS does scrutinize returns claiming it more closely."

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Large charitable donations

The IRS already is known to look closely at returns with a large charitable-donation deduction relative to reported income. For those who are "bunching" their donations, be aware that the move could get more interest than you intended.

Basically, the tax break for charitable contributions is one of the few deductions remaining. Yet to take it, you must itemize your deductions. And for that option to make financial sense, the total of all your deductions would need to exceed the standard deduction — which for the 2019 tax year is $24,400 for married couples and $12,200 for singles. 

So, facing a higher hurdle for itemizing, some taxpayers plan to "bunch" their charitable contributions. That is, you give two years' worth of charitable donations in one year (and nothing the next year) if it would mean being able to get the deduction.

However, the IRS knows how much taxpayers at various income levels typically donate. So if your charitable-contribution deduction is high relative to your income or in comparison to your income peers, look out.

"If you're bunching your contributions, that could spark interest," Shannonhouse said.

Of course, as long as you have the documentation to back up your donations, you shouldn't fear hearing from the IRS.

And remember the contribution limits: You can give cash donations of up to 60% of your adjusted gross income to qualified charities. Other types of donated property also face limits, depending on the type of asset and the organization it's given to.

Odds and ends

Along with making sure you get the nitty-gritty right — claiming all your income, taking advantage of any available tax breaks and ensuring you have the documentation to back it all up — it's wise to closely review the basics before signing and sending off your return.

"Double-check everything — Social Security numbers, your address, make sure all boxes are checked that need to be," said Shannonhouse, at the AICPA. "All those things help prevent your return from getting flagged at the IRS."