The Internal Revenue Service (IRS) processes most tax returns without further examination. However, some returns contain suspicious details, triggering a tax audit. But getting audited doesn’t necessarily mean you did something illegal.
Read on to know what triggers a tax audit and the different types of tax audits.
What is a Tax Audit?
A tax audit is a review or examination of a taxpayer’s tax filings and financial records conducted by the IRS to ensure that all information reported is correct and compliant with federal and state tax laws. Here, the IRS assesses the figures and other details in the return to verify their accuracy.
State tax authorities occasionally conduct audits as well. If you’ve reported the correct income, deductions, and other relevant information, generally, there’s no need to worry.
Four Types of Tax Audits
Here are the four types of tax audits the IRS commonly conducts.
1. Correspondence or mail audit
The correspondence or mail audit is the least severe among the different types of tax audits. Here, the IRS will send you a letter asking for proof of statement or other supporting documents that will allow them to validate the information on your tax return.
2. Office audit
This audit involves meeting an IRS tax auditor in person at an IRS office. The IRS conducts an office audit when your tax return contains issues a correspondence audit can’t address. Here, the IRS agent will interview you about your tax records to confirm if you’ve correctly reported your income, claimed the right deductions, and paid your taxes as required.
3. Field audit
A field audit commonly applies to business owners. In this comprehensive tax audit, the tax agency will thoroughly examine multiple items on the return and will often visit the business in person to review additional records. The IRS agent will provide you with a list of documents you must prepare for the review. At the end of the audit, the agent will give you a copy of the report.
In some instances, the audit report contains the proposed changes to the tax return. However, if you disagree with the information, you have the right to dispute the changes. Here, engaging tax negotiation services can help you deal with the process with less risk and stress.
4. Taxpayer Compliance Measurement Program (TCMP) audit
In this type of tax audit, an IRS auditor carefully reviews a randomly selected return in the taxpayer’s home or office to confirm a possible under- and overreporting of income. The auditor typically asks the taxpayer to substantiate every line on the return. The IRS uses the audit results to measure individual taxpayers’ tax payment compliance and estimate the tax gap among large corporations.
If you are a subject of a TCMP audit, an IRS auditor will likely look through all your lifestyle aspects that they believe may impact your taxable income. You may need to present your birth certificate, marriage license, or other personal documents.
What Triggers a Tax Audit
Here are some of the reasons the IRS conducts a tax audit.
1. You earned substantial income
Earning substantial income suggests a higher likelihood of tax avoidance schemes. In particular, taxpayers making more than $200,000 are more likely to be scrutinized by the IRS than those earning less. High income can be a red flag for the IRS since they mean more investment—such as real estate, employer-stock options, or capital gains—requiring more complex reporting.
2. You failed to report all your income
Failure to report all your income is an audit trigger and can lead to penalties from the IRS. If done willfully, it can even land you in jail. If you forgot to report your income from other sources, such as that from a side hustle, you’d be required to file an amended return.
Employers must file Form W-2 (Wage and Tax Statement) to report their employees’ earnings or the IRS Form 1099 for contractors and freelancers who earn more than $600. The IRS system automatically checks if your reported income matches the information your employer has provided.
3. You spent or deposited a lot of cash
The Bank Secrecy Act requires U.S. banks and other financial institutions to alert the IRS of any instance of suspicious cash transactions involving more than $10,000. Its goal is to detect and prevent money laundering activities.
The IRS could flag you for an audit if you transacted using cash worth more than $10,000. The possibility of an audit increases if your reported income doesn’t support or justify the transaction amount.
4. You are self-employed or an independent contractor
Self-employed individuals like freelancers and sole proprietors are entitled to various tax deductions other taxpayers don’t get to avail of, such as deductions for mileage, meals, travel, and entertainment.
If you’re self-employed and claimed transportation expenses, you must provide documentation of the mileage used for work purposes. Moreover, deducting 100% of your personal car’s mileage as a business expense is going to alert the IRS. A lack of receipts and documentary proof of your claimed deductions can also trigger an IRS audit.
5. You work from home
If you work from home and claim home office deductions, be sure that the office space is used “exclusively and regularly for your trade or business.” Otherwise, the IRS will disallow the deduction during a tax audit.
The eligibility for deductions on using a taxpayer’s home for business purposes is subject to strict rules. Furthermore, the IRS won’t hesitate to investigate if you claimed home office deductions.
6. You claimed your hobby is a business
Business owners can deduct certain expenses incurred from related business activities that are ordinary and necessary.
The tax rules provide guidelines in determining whether an activity is a hobby or a business. Suppose you breed puppies and sell them. If you haven’t generated a net profit from the activity for at least three of the last five tax years, then the IRS will likely not consider it a business.
The IRS will likely audit you if you claimed your hobby as a business solely to get deductions. The hobby loss rule limits deductions to business activities conducted primarily for profit. Hence, if an activity does not serve for profit purposes, then no deduction is attributable to such activity.
7. You have cash or assets in another country
The IRS might investigate if you have cash or assets in a foreign country. The agency focuses on taxpayers who have investments in other countries, particularly in nations with more favorable tax laws than the U.S.
The IRS may obtain your account information from a foreign bank if it thinks you might owe taxes on the money you’ve deposited in it. If it suspects that you possess $10,000 or more in foreign-held assets but have not filed a Foreign Bank Account Report (FBAR) or misreported your income or assets on your FBAR, you may be subject to an audit.
8. You own a cash-based business
You may also come under the IRS’s notice if you run a cash-based business. Salons, restaurants, bars, car wash services, and taxi services fall under this category. The logic is that it’s easy for the proprietors to tuck that $50 away in their pockets and forget about it, therefore resulting in underreported income.
Be Prepared for a Possible IRS Audit
Though it may sound alarming, a tax audit is not something to be feared if you report your income correctly and file your returns on time. However, the process can be stressful. By being aware of what triggers a tax audit, you can avoid being the subject of one.
To ensure a hassle-free tax season, avail of tax negotiation services from professionals like Peace of Mind Tax Help. Our team of leading experts in tax negotiation and mediation can help you minimize your tax liability.
Contact us today to know more about our services!