With the end of the year, many business owners have the fun pleasure of planning year-end tax strategy. It’s that time to make sure we can minimize taxes to the fullest extent the law and ethical consideration will allow.
Tax avoidance is natural, legal, and healthy. Consider some very common forms of tax avoidance: the Child Tax Credit, investing in retirement plans, a Health Savings Account of some sort, or perhaps a tax credit for child care costs such as daycare. These should not be mistaken for “Tax Evasion” which defines the unlawful act with which we are familiar.
That said, there are many red flags the IRS is looking for that could easily land you in the magical place called “Auditville.” Let’s consider a few:
While an error in basic arithmetic might not cause a full blown audit, it’s the most common reason that Americans receive stressful letters from the local IRS office. Use a calculator, and check your numbers twice.
Unusually High Itemized Deductions
The IRS uses a secret formula to calculate what your deductions should be. If computer scan of your returns shows that your deductions for charity, travel and entertainment, and healthcare are out of line with your income, you’ll be on their radar.
Self-Employed/Schedule C Filers
Small businesses are believed to be particularly creative with expenses. You might be at extra risk if you have been losing money for a few years in a row, taking a home office deduction, and preparing your returns yourself without an accountant.
Lots of 1099s
Over the last decade, the IRS has been cracking down on the practice of misclassifying employees as contractors. It is estimated that more than 3 million workers in the US are misclassified as independent contractors instead of employees. The IRS has changed its rules over the years, and it now presently examines both who has behavioral and financial control and the relationship between the parties involved.
Be especially careful to report all your income. If your divorce terms are defined by pre-President Trump tax law changes, or if you’ve received a 1099, the IRS’s computers will notice if you did not report that income. If your former spouse reports alimony paid that you are not reporting, there will be a big bullseye on your tax return.
People have the mistaken impression that the auditor won’t come knocking twice; but beware the taxman who often rings twice … or more.
If you are an investor in a partnership or corporation that the Federal IRS examined, then you may be next.
Disgruntled divorcees and former employees are a regular source of IRS tips about their former spouses and employers. Revenge isn’t the only reason motivating whistleblowing to the IRS; the law allows it to pay cash rewards to informants (up to 30% of what is collected). In 2019, the IRS paid out over $120M in whistleblower awards.
While it may seem that anything you do can trigger an audit nowadays, some activities are far higher risk than others. In the end, the best advice that can be given is to be honest, make things no more complicated than they need to be, and be modest. The fewer tickets you buy into the audit lottery, the lower the chances you’ll be audited.