6 red flags that can get you audited
There's nothing quite as heart-stopping as a notice from the IRS. Sometimes it's to raise a question about an item on your return; other times you may get a notice that you owe money. If you're really unlucky, you may find out the IRS is auditing your return. Fortunately, about 80 percent of audits are simply "correspondence audits," meaning the IRS is "asking for documentation or showing an adjustment made based on information received," says Lisa Greene-Lewis, CPA and TurboTax tax expert.
But no matter how innocuous, the only time most people want to get mail from the IRS is when they are waiting for a refund check.
Here are six red flags that can trigger questions from the IRS, or even a full-blown tax audit.
Not claiming income
You know all those W-2s and 1099 forms you get in January and February? The IRS gets copies of those forms, too, and they will match them with the income you report on your tax return. "Taxpayers must always make sure that the income on Form W-2 and Form 1099 match the reported income on their returns," says Stephen F. Lovell, president of Lovell Wealth Legacy.
You may not hear from the IRS about this kind of problem right away. I once received a notice from the IRS two years after I failed to report income from a 1099 form I never received. (I'd moved, and I assume it went to my old address.) And we've heard from taxpayers who've received notices from the IRS telling them they owe taxes because they failed to report income from canceled debt (reported on Form 1099-C) several years after the fact. If you've moved in the past few years it's possible the IRS got a form reporting income but you didn't. If that's a concern, order a wage and income transcript from the IRS for the years you are concerned about. (Note: You likely will not be able to get your transcript for the current tax year until about 3-6 weeks after you filed your return and paid what you owe.)
Daring deductions
"If your deduction claims are way off, you're likely to get questioned," says Kay Bell, tax blogger at Don't Mess with Taxes. What constitutes "way off?" The IRS can compare tax return data to averages, explains Bell. "Known as the Discriminant Information Function, or DIF, this computer-scoring system looks at average deduction amounts." That doesn't mean you shouldn't take legitimate deductions; just be prepared to back them up.
Business losses
Self-employed, or have a side business? If you file Schedule C, the form that reports business income or loss, understand that a loss could cause the IRS to look more closely. "If you show a loss, the IRS's question is, "Is this a real business or just a hobby?" warns Dan Pilla, author of How to Win Your Tax Audit. The IRS will look at whether expenses were "incurred for the intent of earning income and not just pleasure" as in a hobby, he says. Making a profit doesn't automatically ensure that expenses won't be scrutinized. You'll need to be able to demonstrate a legitimate business purpose if questioned.
Questionable charitable deductions
Did you donate an old car or boat? If the value of a single item you donate is $5,000 or more you'll need to get an appraisal. Cleaning out closets and donating clothing or other household items to charity? "It's also a good idea to take pictures of donated non-cash items," says Greene-Lewis. Of course, there's an app for that: TurboTax ItsDeductible can help you figure out how to value those items and track your donations. I use it myself and find it helpful for figuring out how much that purse or stack of books I'm giving to my local Goodwill might be worth.
Also remember that in order to be deductible, charitable gifts must be made to a qualified organization and you can only deduct the amount that exceeds the value of any benefits you received (ticket to a concert or dinner at a restaurant, for example). The IRS also warns that if you want to deduct contributions of "cash or property equaling $250 or more you must have a bank record, payroll deduction records or a written acknowledgment from the qualified organization" that satisfies IRS requirements. More details on charitable deductions can be found on the IRS website.
Failing to properly pay household employees
If you employ a nanny, housekeeper or an aide to help care for an elderly member of your family, you may run into any of three common tax traps, warns Tom Breedlove, Care.com Home Pay Household Tax Expert. The first is paying them under the table. If your household help earns $1,900 or more in a year, you must have taxes withheld from their pay, and you -- as the employer -- must file and pay state and federal taxes. While you may have an arrangement with your caregiver to pay them in cash, if they try to collect unemployment benefits, your off-the-record arrangement could backfire.
In addition, Breedlove warns that "household employees must be paid overtime for hours over 40 worked in a seven-day workweek." Again, this could come up if the employee files a wage dispute. "On top of this, families could be audited, which can result in having to amend previous tax returns and pay additional taxes on the wages that were incorrectly reported," he says. And lest you think that just giving the employee a 1099 instead of W-2 form solves the problem, think again. "The IRS equates this practice to tax evasion," he says.
You and your ex don’t match up
Are you paying alimony? Collecting alimony? Then make sure the amounts you and your ex report match up. "Although divorced, ex-marrieds must make sure that their respective returns mirror each other," says Lovell.
Similarly, if you have children, only one of you gets to claim child-related tax benefits such as the child care tax credit, the dependency exemption, and the head of household filing status. Who gets to claim what will depend in large part who is considered the custodial parent. You'll find more details in IRS Publication 501.
Again, don't let the fear of an audit stop you from claiming legitimate tax deductions. And keep in mind that when it comes to any kind of audit, TurboTax says that less than 1 percent of tax returns reporting incomes under $200,000 get audited.
An audit in and of itself does not affect your credit: It's only when you owe the IRS money you can't pay right away that unpaid taxes may affect your credit. That's because the IRS may file a Notice of Federal Tax Lien which will create a credit-damaging tax lien on your credit reports. (You can check your free credit report summary on Credit.com to see if there are any tax items that are impacting your credit.) And even then, if you can work out a payment plan with the IRS you can often get the tax lien removed from your credit reports while you pay off your tax bill.