Increased IRS funding means that audits of wealthy taxpayers will likely increase. That means clients need to be aware of the circumstances that could trigger an IRS investigation, advisors say.
“Wealthy clients are thinking about audits, mostly because of all the press about the staffing up of agents,” said Barbara Taibi, partner in the Private Client Services Group for Eisner Advisory Group LLC in Iselin, N.J. “I’m seeing audits usually when there is a large transaction that can’t be digitally matched by the IRS to source documents they receive. On the state level, residency audits are very common, particularly after Covid and everyone moving all over the country without considering state tax laws.”
Certain transactions involving a lot of money could attract the attention of the IRS, advisors said.
“Audits on ultra- and high-net-worth clients are likely to increase, though the probability of audit is remains low,” said Mallon FitzPatrick, managing director and principal at Robertson Stephens Wealth Management in New York. He added that red flags that could trigger an audit include sizeable transactions, especially those pertaining to income. “Rental losses, business sales, charitable deductions, gifts, cryptocurrency transactions and foreign transactions. Other audit triggers may be high self-employment income, missed RMDs, suspicious business expenses, failing to report foreign accounts and self-dealing for private foundations,” he said.
Non-cash charitable contributions are “by far the most audited area for the wealthy,” Taibi said. “Non-cash contributions—paintings, houses, stock, collectibles and so on—need to be reported on IRS Form 8283 [which] specifically lays out the contribution amounts that require a valuation of the property gifted, the required signatures by the charity receiving the property, the valuation dates, the amount allowed as the deduction and all other information related to how the property was acquired by the taxpayer and their original cost. If the form is not completed property and completely, the IRS will try to disallow the entire deduction for the contribution.
“This is not a situation where we can just amend the form and do it correctly,” Taibi said. “The taxpayer only has one chance to complete it correctly.”
Documentation failures are another potential trigger, advisors said.
“One of the big triggers is missing an income source and not reporting it with the return,” said Chris Murray, practice leader in tax services at Aspiriant. “This could be a result of a 1099 with income or a new investment that’s reporting a K-1 that’s overlooked.
“Clients with Schedule C activity are definitely the largest group with audit risk,” he said, adding that Schedule C business activity often includes travel and entertainment, business use of an auto or home office deductions—all items that get a lot of scrutiny from the IRS.
Lack of income is another red flag.
“Is your Schedule C income a hobby or a business? Taxpayers who only have losses from consulting work or side business can be flagged if they never make money,” said James Chalmers, senior advisor at Moneta in St. Louis.
“LLCs that have flow-through entities or self-employed individuals generally have more flexibility with expenses and income,” Chalmers said. “Sometimes they may not have the best reporting, which causes errors. This can be a gold mine for an IRS auditor.”
Residency audits are another trouble area. New York, New Jersey and California, for example, have a reputation for being aggressive in auditing for “former” residents moving away but maintaining residency ties. “States are just now catching up to people who failed to properly report income on their 2020 and 2021 returns,” Taibi said.
Taibi also warns about IRC Section 1202 stock transactions, which allow for the partial or total exclusion of capital gain on the sale of qualified stock. “The stock must meet certain requirements when issued and be held for a certain number of years to get gain exclusion,” she said.
Avoiding an audit comes down to not giving the IRS a reason to investigate, advisors said.
“We preach to clients to stay away from operating in the margins of the tax code,” said Bruce Primeau, a CPA and president of Summit Wealth Advocates in Prior Lake, Minn. “Don’t give the IRS or a particular state more reasons to audit you than they already have.
“Document everything,” Primeau said. “Even if it seems like overkill, the burden of proof is on the taxpayer and not the IRS. Guilty until proven innocent.”