Jewett, Inc.

1. Missing income

Income derived from regular wages automatically have taxes withheld, and employers report those taxes to the IRS. However, taxes aren’t normally withheld from nonwage income—including business income, capital gains, dividends, interest, rental income, and royalties — making it more prone to discrepancies and examination by the IRS.

What to do

Your financial firm will send 1099 forms for capital gains, dividends, and interest, which must be accurately accounted for on your return. For income that doesn’t pass through an intermediary, such as business or rental income, you’re required to document and report it yourself. Underreported income is often due to a missing or out-of-date 1099, inaccurate accounting practices, or both. Whatever your sources of income, you need to ensure your return reflects them all.

Don’t miss a dollar.

Here are the most common forms that report income to the IRS.

2. Large swings in income

Individuals whose income fluctuates significantly from one year to the next can also find themselves in the IRS’ sights. This can be the case for those who are self-employed or own a business. Big changes in income are a huge red flag for the IRS because they sometimes signal underreported income, either in the current year or in previous years.

What to do

Consider including notes or an explanation with your tax filing if there are big changes in your expenses or income from year to year. For example, if your business income plunged because you lost a large account, you’ll want the IRS to take that into consideration when determining whether an audit is warranted. If you file electronically, most tax software allows you to add supplemental documentation and schedules to help explain your situation.

3. Business losses

Turning a profit can be challenging for any business, especially those just getting off the ground. However, the IRS will take notice if you claim losses year after year or if a loss is substantial. You’re less likely to be audited in the first few years, when losses are normal and expected. Over the longer term, though, businesses are supposed to make money—and if yours doesn’t, the IRS will want to know why.

What to do

Keep careful records for at least seven years that detail every dollar coming into and going out of your business. What’s more, if your business is a sole proprietorship, the IRS may question whether it’s more of a hobby—in which case the loss may not be deductible.

4. Questionable deductions

While your deductions may be well founded, some may nevertheless trigger a second look by the IRS. In particular, be mindful of:

• Outsize charitable donations: The IRS flags charitable deductions that far exceed the average donation of those at a similar income level. Be aware, too, that such deductions are capped to 60% of your adjusted gross income (AGI) for cash donations and 30% of AGI for stocks and other property.
• Passive losses on a rental property: If the costs to operate a property exceed the rental income it generates, you may not be able to claim a loss—unless:
  • You own at least 10% of the property, you’re personally involved in managing it, and your modified adjusted gross income is less than $100,000 — or:
  • You’re a qualified real estate professional (meaning you spend at least 750 hours annually on such work and it accounts for more than 50% of your annual working hours) and you take an active role in the management of the property.
• Unqualified home-office deductions: Unless you’re self-employed and conduct the majority of your business from your home, you cannot deduct any home-office expenses. People who work from home may assume they can take this deduction. Unfortunately, regular employees don’t qualify, even if they pay out of pocket for all or part of their home-office setup.

What to do

Have supporting documentation for any deduction on your tax return, especially those that are significant or subject to special rules, such as rental losses. You can’t always avoid an audit, but thorough records that support your deductions can quickly appease most auditors.

5. Undervalued assets

Estate tax returns tend to be audited at a higher rate than individual returns. In 2020, for example, the IRS audited four times as many estate tax filings as individual filings. The biggest reason? Undervalued assets. The IRS has seasoned valuation experts, and if they think the estate has valued its assets too low, an audit could be just around the corner.

What to do

When valuing assets with no public market price—such as real estate, art, or a closely held business—executors of large estates should average the estimates from two or three qualified appraisers. Should the valuations come into question, having multiple appraisals can help substantiate your position.

The buck stops with you.

Even if you hire a professional to prepare your taxes, the accuracy of your filing ultimately falls on your shoulders. I can’t tell you how many people just sign their professionally prepared tax returns and never review them.

Going through these steps may help reduce the likelihood of an audit, but if one is unavoidable, it also can help ensure your tax return stands up to scrutiny. If you followed the rules, retain good documentation, and have a trusted tax advisor to represent you, the process can actually go quite smoothly.

A tale of three audits

The IRS has three main types of audits—some being more painful than others.

• Correspondence audit: The most common IRS audit, this typically is conducted by mail and sent for reasons such as missing information, small balances owed, or identity verification. (Note: Be aware that scammers have been sending fraudulent letters to collect funds from unsuspecting taxpayers. Identifying fakes isn’t always easy, but typical red flags include demand for immediate payment, threats of jail time, and grammatical errors and misspellings. If you’re unsure of a letter’s authenticity, you can contact the IRS at 800-829-1040 or visit its website to confirm a letter’s legitimacy or report an incident.)
• Office audit: In this type of audit, taxpayers receive a written summons to go to an IRS office to meet with an agent. This generally happens with more complex tax returns or if the return has multiple items being questioned.
• Field audit: The most comprehensive type of audit, this in-person meeting typically occurs at the taxpayer’s business or home to conduct a thorough examination of the return in question. These audits can often last several weeks or even months, depending on the issues being reviewed and the complexity of the tax return.

For every type of audit, the IRS will provide in advance a written request for the specific documents it wants to see.