The idea of a tax audit, to almost any American, is a scary thought and this year, we will likely see an increase in the number of audits conducted. The increased quantity, combined with the heightened complexities of filing returns due to pandemic-inspired federal grant, loan, and tax-credit programs may be shaping up for an explosive tax season with many taxpayers impacted.
Fewer than one million Americans get audited each year, but to avoid an audit, the best thing you can do is file your return correctly and completely. Those who do not file their taxes, or underreport their income are typically at the top of the list when getting selected for audit, but some other red flags may also trigger an audit. Here are a few:
Child Tax Credit
Some changes made to the Child Tax Credit in 2021 could trigger an audit for several reasons. The expansion of the credit increased the credit amounts to $3,600 (children under 6 years old) and $3,000 (children ages 6 to 17) and also allowed advanced payments in the amount of half the credit to be paid out monthly. About 60 million children were able to benefit from these advanced payments, but now there is a catch.
Parents must reconcile the correct amount received with the amount they qualified for. This may be much more complicated than anticipated due to the IRS sending incorrect amounts out in Letter 6419. Additionally, for joint filers there is some additional legwork needing to be done as each parent should have received half of the advanced payments.
Inaccurately reporting the amount you collected of the advanced payment, or misstating your income to receive more of the credit are the two largest “red-flag raisers” when it comes to the CTC.
Cryptocurrency Transactions
If you believe the IRS is not taking cryptocurrency seriously, think again! The IRS is again asking if you have bought, sold, traded, or disposed of any financial interest in virtual currency, and with more experience than ever under its belt, the IRS poised to crack down on taxes relating to the virtual currency. Additionally, there is some increased motivation to start cracking down on crypto as the IRS has a mandate to collect $30 billion in crypto tax revenue over the next 10 years.
The IRS has also seen tremendous growth in this industry, but the number of people reporting their crypto income for tax purposes is growing at a much slower rate, which signals underreporting. Underreporting income from cryptocurrency and not listing all of your taxable trades individually are the biggest “red-flag raisers” for the IRS, so be sure to speak with a tax specialist if you need assistance this season.
Large Charitable Donations
For charitable donations to be deductible they must be given to qualifying organizations such as religious organizations and nonprofits. If these deductions are high compared to your annual income, they will likely be reviewed and may cause an audit to be conducted.
This is more cause for concern than ever as the limit for these deductions was expanded to 100% for cash donations in 2020 and 2021. Additionally, the limit is lower for donations that are not cash or made to qualifying organizations (such as certain private foundations). It would be smart to keep detailed records of all receipts in case an audit is to arise from this.
Rental Income
The short-term rental industry has been growing at an unprecedented rate thanks to companies like Airbnb, VRBO, and more. Many people who are new participants in this industry, may not realize that their income is considered passive, rather than active income. Since their income would be considered “passive” and you have a rental loss for the year due to operating costs being greater than your rental income, you ARE NOT able to deduct this against your W-2 income.
Underreporting, claiming large rental losses as deductions, and excessive and vague deductions are all “red-flag raisers” and could cause an audit.
Home-Office Deductions
Due to the many changes that came as a side effect of the pandemic and confusion over who qualifies, home-office deductions may be one of the biggest trainwrecks this year. The Tax Cuts and Jobs Act in 2017 suspended tax write-offs related to home offices for employees through 2025. This disqualified millions of people who now work remotely due to the pandemic from receiving deductions., meaning only self-employed individuals can claim the deduction in 2021.
In addition to self-employed individuals being the only ones who qualify for these deductions, there are still some things that may get you caught up in an audit. Most importantly, you must have an entire room exclusively and regularly used for business, those working from their living room will not qualify. “Red-flag raisers” will likely be restricted to those claiming a large percentage of your home’s space may raise some eyes at the IRS as well as those who claim these deductions while being a W-2 worker.
Early Withdrawals from IRAs or 401(k)s
Payouts from a traditional IRA or 401(k) before becoming 59.5 years old typically will open you up to a 10% penalty on top of regular income tax. Roth accounts are subject to the same 10% penalty, but with only parts of early distributions able to carry tax liability. These both are with a few exceptions to be had, see here for the full list.
The Covid-Related Tax Relief Act of 2020 waived the 10% penalty to provide relief to taxpayers during the pandemic. The 10% penalty, however, was reinstated for this tax year, which may trip some taxpayers up when filing. Failing to report income from your IRA or 401(k) distributions, and not including documentation in your 1040 may cause you to be a “red-flag raiser”.
Education Tax Credits
Two types of education-related credits were issued last year, the American Opportunity Tax Credit and the Lifetime Learning Credit. The American Opportunity Tax Credit is in the amount of $2,500 and is primarily for students pursuing an undergraduate degree, while the Lifetime Learning Credit is for people pursuing a career change, or advanced educational training at a postsecondary school. Both of these credits come with eligibility requirements, and they are not allowed to both be claimed in the same year.
Claiming the wrong, or both credits in the same year; claiming multiple tax breaks for the same college expenses, and not submitting Form 8863 are all reasons to consider a taxpayer a “Red-flag raiser”.
Small Businesses
Small businesses, as always, will continue to receive a lot of scrutiny from the IRS this tax season, especially S-Corps, Sole Proprietorships, and partnerships making over $100,000 a year and are cash-intensive. This is typically a category where excessive deductions and underreporting of business income are often suspected. Proprietors and partners of small businesses also sometimes may artificially declare small salaries for themselves to lessen the tax impact on the company and themselves.
On top of those underreporting salaries, other “red-flag raisers” may come from those who received emergency stimulus loans in the Paycheck Protection Program Plan under the CARES Act also should be vigilant. These loan amounts could be taxable income if the proceeds were used improperly. The proper use for the loans was to apply at least 60% of the proceeds for payroll costs, utilities, rent, and mortgage interest.
Wrap Up
While these are just some of the reasons an audit could be sprung on you this year, it is not a complete list. The IRS is looking to crack down on taxpayers more than ever this tax year and many taxpayers are already worried. If you feel this way, it is important to speak with your tax advisor as soon as possible and give them details as to why. Our tax professionals have experience not only with preparing for an IRS audit but also dealing directly with the agency to set you up for the highest chance of success.
Call DSJ at 516-541-6549 and visit our website for more information.