Potential IRS Red Flags
No Accounting or Tax Blog would be complete without an article or link to an article concerning potential IRS red flags that increase the risks of an Audit or Examination.
Nothing earth-shattering or revolutionary here…this subject has been covered many times, by many Authors. But this is my take in my own words.
The purpose of this short list is simply to inform. It is not a recipe or guarantee that if you refrain from the actions in these examples that you WON’T get audited.
No Accountant or Tax professional can guarantee the actions of a governmental taxing authority like the IRS. You could have two taxpayers with completely identical tax situations, and the IRS could potentially treat each of these situations, differently. Auditors and Examiners are all different and their treatment in each situation will likely depend as much on their actions as well as how the IRS chooses to apply their resources.
That being said, here is a short list (not inclusive) of those that I think are particularly problematic for both Individual as well as Business filers (taken from my December 2021 Newsletter):
- Discriminant Scoring: This sounds more technical than it really is. Simply put, the IRS computer scores tax returns with a high probability of unreported income based on IRS experience with returns that are similar in nature.
- High Income Earners: The IRS will pay special attention to those taxpayers with high incomes that failed to file a return for one or more prior years. The IRS wants to remind these taxpayers of their obligations to file and pay the amount of tax that they are legally obligated to pay.
- Information Matching: The IRS matches income reported to them on W2’s or 1099’s with amounts reported on the return. If the figures don’t match, you’ll likely get flagged with a Notice.
- Random Selection: This is the IRS Roulette Wheel, so to speak. If your “number” comes up, they may decide to contact you. However, returns that are accurate (arithmetically) and compliant with the tax code with no obvious statistical outliers (like $100 in business income and $100,000 in business expenses), and returns with figures that tie to the income reported to the IRS from W2 and 1099 statements, they (the IRS) will likely close your case, quickly and move on.
- Related Exams (Partnership or S-Corp) and then Partner or Shareholder: Partnership or S-Corporation returns that get flagged will extend to those Partners or Shareholders as their income, gains, deductions and losses “flow” to them from these particular business entities.
- Abusive Tax Positions or Tax Shelters: A taxpayer may have an argument for taking an aggressive tax position(s), but (obviously) you should not consider taking positions that are not compliant with the tax code! Taxpayers that subscribe to these shady tax promotion schemes can find themselves staring at audits if the IRS busts the promoters and goes after their subscribers.
Each of these red flag examples for Individual Filers can also apply to Businesses.
- An overabundance of rounded numbers. It’s fine to round numbers to the nearest dollar, but a return littered with $1,000, $1,500 or $2,500 figures? The IRS may think the taxpayer just created these numbers out of thin air.
- Large Numbers on a Business Return: This will get the IRS’s attention, particularly if there are large changes, year-over-year and if these changes create a large loss.
- Rounded Numbers for Vehicle Mileage: The IRS expects business owners to keep updated vehicle mileage logs. Again, if the numbers look contrived, the IRS may challenge you and deny your deduction(s).
- Low/No Salary and Large Distributions for S-Corporation Officers: One of the benefits of an S-Corp is that Shareholders/Officers avoid self-employments taxes and Social Security taxes are assessed only on their W2 income. The catch is that this W2 income must be reasonable. So, if Shareholders/Officers thwart this by taking distributions in lieu of salary, that’s a red flag. There are no bright lines that define what is or is not reasonable and every situation is different (it’s industry specific as well). For this, you need to consult a tax professional.
Related to these potential red flags, here are a few other issues to consider:
Fines and Penalties
- Underreporting Income. The IRS will assess whether the underreporting is willful and deliberate, bordering on criminal evasion or a mistake that the taxpayer can show reasonable cause – in other words, it was unintentional.
- Not willful or deliberate. The IRS considers underreported income to be substantial if the underreported amount exceeds 10% of the amount of tax liability and they will assess a 20% penalty. If they believe the taxpayer was negligent in the application of the tax laws to their specific situation, they can assess (again) a 20% penalty, but they can’t stack both; it’s either negligence or a mistake that led to a substantial underreporting.
- Willful and deliberate. If the IRS believes a taxpayer acted with malice to deceive, fines and penalties can approach 75% of the underreported income. So, if a taxpayer failed to report $50,000 in income and the IRS concludes that the taxpayer acted to evade taxes, they could assess a penalty/fine of $37,500.
- Failure to File. One of the more common penalties. The penalty is 5% of the unpaid tax for each month or partial month that the return is late. This is capped at 25% of the amount of unpaid tax. If the return is at least 60 days late, the minimum amount of penalty is $435 or 100% of the unpaid tax, whichever is less.
- Failure to Pay. The IRS will assess a penalty of 0.5% of the unpaid amount of tax for each month or partial month that the tax remains unpaid. This penalty is capped at 25% of the amount of unpaid tax. If the IRS serves notice of an intent to levy and the taxpayer fails to pay the amount due within 10 days of the notice, the IRS can assess a 1% penalty on the unpaid amount for each month or partial month payment is late. If you’re late, both in filing your return and paying tax owed, the penalties won’t stack. Instead, the IRS will assess a combined penalty of 5% for both.
Here’s a link to the IRS site re: Failure to File Penalties. Additional detail – failure to file.
Here’s the link concerning Failure to Pay Penalties. Additional detail – failure to pay.
Wishing you a stress-free tax season (as stress-free as you can make it).
— The Engineered Accountant