With the stress of filing your tax return now conveniently in the rearview mirror – or launched on the road to the extension until October 17 – many people have started to worry about their chances of being audited.
The numbers suggest that’s unlikely. Still, a host of pandemic-related tax changes have created several potential minefields, and the sheer complexity of the tax code provides plenty of room for a taxpayer to make math or clerical errors — and worry.
“People are almost always afraid of being audited,” said Christopher Smith, the founding tax partner of Brandywine Oak Private Tax Advisory, a financial advisory firm in Kennett Square, Pennsylvania. “To the point that some people are afraid to take things they could legally.”
Last year, only 4.5 out of 1,000 people who earned between $200,000 and $1 million – less than half a percent – were audited, according to Syracuse University’s Transactional Access Records Clearing House, a research center that obtains internal records from the IRS under court order. A decade earlier, TRAC said, the odds were around 10.5%. Two years ago, less than two in 100 taxpayers earning more than $1 million were audited, a 72% drop from 2012, when there were fewer millionaires.
Formal Internal Revenue Service scrutiny has been in decline for a decade due to budget cuts, computer systems that date back to the Kennedy administration, and dwindling ranks of law enforcement personnel. In the more than two years since the pandemic emerged, the crisis-hit agency has struggled to manage gigantic backlogs, trillions of dollars in government assistance to individuals and businesses and a tsunami of phone calls from frustrated taxpayers – 16,000 per employeeaccording to a senior Treasury official.
In general, the IRS goes after people with the highest and lowest incomes. Although the agency usually has three years from the date you file a return to scrutinize it, it can go back six years if it suspects you under-reported large amounts.
Who is audited
Just over five out of 100 people earning at least $10 million in 2018, or 5.3%, were audited in 2018, according to the most recent public data from the IRS. This is a fraction of the rate of 21.5% in 2010.
The audit rate for those earning between $1 million and $5 million fell to 0.6% in 2018. It was 8.2% in 2010.
Those who earned at least $100,000 but less than $1 million had a 0.1% to 0.2% chance of being audited in 2018. The rate ranged from 0.8% to 8.2% in 2010.
In contrast, people earning less than $25,000 are five times more likely to be audited than everyone else, according to TRAC. This is largely due to the Earned income tax credit, a roughly $60 billion anti-poverty program serving 25 million taxpayers who each year mistakenly pay out about a quarter of their dollars due to error or fraud. Claiming the EITC in 2018 gave you a 0.9% chance of being audited, according to the most recent data from the IRS. TRAC says the rate is closer to 1.3%.
The IRS calls audits “exams“, and they come in a variety of forms – usually by mail, and less often face-to-face, or through a desk audit (when you drag yourself and drag documents to a local branch of the IRS) or a dreaded audit in the field, when the agency visits your business or your home. Either way, the country’s tax collector wants to see if you are accurately and truthfully reporting all your income, expenses, deductions, credits, and losses, whether in the United States or abroad. Some audits are the result of arbitrary bad luck – you are chosen from a random sample. Others emerge as a result of a computerized screening involving secret IRS formulas aimed at bringing up ‘red flags’ that mark you as an outlier in a group of your peers.
Here are three big audit triggers this filing season that have popped up since COVID-19 altered work and life, according to accountants and financial advisers.
Help for businesses in the event of a pandemic
Since the outbreak of the pandemic in early 2020, the federal government has provided loans, grants, and tax credits to struggling Americans and businesses. All of these payments have the potential to erase a return and delay any refund or trigger an audit.
Recipients of the Small Business Administration’s roughly $800 billion paycheck protection loans to help businesses stay afloat and keep workers employed don’t have to report the money as taxable income on their federal returns if not pardoned.
If the loans are forgiven, they still don’t count as taxable income — but the clean slate must be reported in a separate statement that you attach to your declaration. Unlike the federal government, some statesincluding Florida, Nevada, and North Carolina tax-exempt PPP loans.
Professional expenses paid with PPP proceeds, even forgiven, are deductible. But loans cannot be used to pay business taxes. Recipients must use at least 60% of the proceeds for payroll and the remainder for utilities, rent, or mortgage interest. How would the IRS know if you are not meeting these goals? Through payroll records and other documents submitted by a taxpayer. The agency conducted more than 660 investigations into allegations PPP Fraud totaling more than $1.8 billion.
Remote work from a home office
Prior to the tax code overhaul in 2017, anyone who worked from home could potentially claim the home office deduction, whether they were employed by a company or worked for themselves. Since then, only the self-employed can claim the allowance. With the pandemic having sent legions of salaried employees home to work in makeshift offices, millions of taxpayers cannot claim the deduction.
Scores who have lost their jobs can potentially claim the benefit. But the demands are pungent. IRS rules state that you must use part of your home “exclusively and regularly for the conduct of business.” This may allow you to deduct a percentage of your mortgage interest, insurance, utilities, repairs, and depreciation for the square footage of the work area. Placing your laptop on the dining room table or next to a toddler’s playpen doesn’t count. Smith said the home office deduction was one of the main triggers.
Things can get tricky with state taxes when you live in one state but earn income in another state. If you decamped from Chicago to your vacation home in Phoenix to ride out the pandemic, you may owe taxes to both Illinois and Arizona. Some states have reciprocal agreements to credit a taxpayer related to both states, but others do not.
Big jumps in revenue
If you own a company that has gangbusters despite the pandemic — and yes, they do exist — soaring profits may be a red flag. “What I’ve seen is that dramatic jumps in income or expenses can tend to trigger audits,” said Clark Kendall, president and CEO of Kendall Capital, an independent financial advisory firm. in Rockville, Maryland. “For some people, it’s just part of doing business. For others, they have sleepless nights.
The IRS is always on the lookout for cash-intensive businesses that may underreport revenue, such as restaurants and beauty salons. These companies, some of which are PPP recipients, tend to be run as private entities, such as an S corporation or a limited liability company.
But family businesses aren’t the only ones to fall under the microscope. In late 2020, a senior IRS official said the agency increase its scrutiny of small businesses and newly formed partnerships by 50% by 2021. Areas of focus for the IRS include self-employment, cash businesses, cryptocurrencies, and income that is not reported on a Form 1099, possibly because “A taxpayer invests in foreign countries,” said Eric Bronnenkant, tax manager at robo Advisor Improvement.
Samuel Landis, a tax attorney in Beverly Hills, Calif., said the main trigger for auditing a return is expenses that make up a high proportion of income. How high an IRS secret is: Landis said the agency typically takes a sample of 10,000 returns filed by taxpayers in a particular profession to determine a risk ratio. “If you’re out of ratio,” he said, “you’re pulled for an audit.”