If there’s anything that Americans dread more than doing their taxes, it may be the prospect of getting audited by the IRS.
Fortunately, your chances of being audited by the Internal Revenue Service are pretty slim. Less than 1 percent of taxpayers were audited in 2014. The number of audits is expected to decline even further this year after budget cuts prevented the agency from replacing retiring auditors. Funding for the IRS has fallen nearly 20 percent since 2010. And if Ted Cruz is elected, you may not have to worry about audits at all, since the candidate has promised to eliminate the IRS altogether.
The IRS considers audits critically important in keeping taxpayers honest, and they’re also a significant money maker. Last year the service took in more than $57 billion from “enforcement” actions, up from $50 billion in 2012. That figure includes not only audits, but also collections activities, results of appeals, and programs that match documents such as W-2s that are sent to the IRS and another government agency.
To choose which returns to audit, the IRS uses its computerized Discriminant Function System (DIF), which assigns a score to each return indicating its potential for questionable issues. A high DIF score means that your return is more likely to get audited. While IRS hasn’t released details of what goes into that score, there are some known red flags that might trigger an IRS audit:
1. You are a high earner.
High earners are a big target for IRS audits. Overall, 0.86 percent of all taxpayers were audited in 2013, the most recent data available. That jumped to 1.75 percent for taxpayers who earned between $200,000 and $500,000 and 3.62 percent for those who earned between $500,000 and $1 million. The IRS audited 6.21 percent of returns from taxpayer who made more than $1 million, and 16.22 percent for those earning more than $10 million.
2. You’re self-employed.
When you work for a large corporation, your employer typically withholds your taxes throughout the year and reports your income to the IRS, making it a lot harder to find wiggle room in the numbers, intentionally or unintentionally. Because it’s easier to fudge figures on both the revenue and the expenses side when you work for yourself, the IRS may take a greater interest in your returns.
If you’ve got a business that shows losses in consecutive years, that could also trigger an audit. “That could indicate that this is not a business, but really a hobby,” says Annette Nellen, professor of accountancy and taxation at San Jose State University.
3. You have a shady tax preparer.
Once the IRS identifies a tax preparer who has cut corners, the agency may go over some or all the returns that the preparer filed to find other potential discrepancies. “If there is a bad preparer doing unscrupulous things, whether you knew about it or not, you still will have to pay back any money you owe,” says Mark Steber, chief tax officer at Jackson Hewitt Tax Services.
4. You filed by hand.
Four out of five tax-filers now e-file, but there is still a die-hard contingent that prefers the old pen-and-paper method. Using software to complete your returns limits the potential for many mistakes such as miscalculations, transposed digits, or leaving required fields blank. But those who file by hand have a greater likelihood of making mistakes, ones that the IRS may notice.
5. You are part of the gig economy.
There’s been an explosion in the number of freelance workers in recent years, which means more people are collecting 1099s at tax time. Companies must issue this form to contractors who have been paid more than $600 in the past year. The number of 1099s issued has increased by more than 10 percent since 2010, according to an analysis by the Bay Area Council Economic Institute.
Every 1099 that a company sends to you is also sent to the IRS. Then the agency uses “document-matching” programs to match what taxpayers report on their returns against what the IRS receives from other sources. “If you haven’t reported something, [the IRS] will catch it right away and come after you,” says Rene Verghese, a CPA with Schulman Lobel Zand Katzen Williams & Blackman in New York City.
For small discrepancies, the process for reconciling is much less invasive than a typical audit. You’ll get a letter from the IRS requesting payment, and you can write a check to clear up the matter.
6. Someone ratted on you.
The IRS rewards whistleblowers with a cash reward for information that leads to a successful audit. In 2014, the service paid out more than 100 rewards worth more than $52 million in total. Additionally, the IRS in the past has launched investigations based on news reports and even social media posts.
7. You claim large deductions.
Unusually large write-offs — especially relative to your income — can attract IRS scrutiny. Charitable donations, especially non-monetary kinds, are among the most common to contain a discrepancy between the value of the specific good and the actual write-off. Like document matching, discrepancies for charitable write-offs typically lead to a letter from the IRS asking for additional documentation. If you can provide it, you can put the matter to rest. Otherwise, you may have to write a check to Uncle Sam.
8. You messed up your Obamacare forms.
If you signed up for Obamacare through a marketplace, you should get a 1095-A form, which helps determine if you received the correct subsidy amount, if you must pay a penalty, or if you can claim an exemption. If you received health insurance through work, you have to check a box showing you had coverage and you’ll receive a form proving it from your company. If you don’t have minimum health coverage, you’ll have to pay a penalty of $325 per person, for a maximum of three people, or 2 percent of net household income. It’s new, and it’s confusing, but if you get any part of this wrong, expect to get a letter from the IRS to reconcile it.