Red Flags That Can Trigger An IRS Audit Of Client Tax Returns

Taxpayers fear few things as much as they do audits. And the wealthier your client, the greater the odds his or her tax return will be examined.

“The IRS is looking to more than recoup the expenses it incurs in an audit and is looking for the larger fish and the filings more prone to error or misjudgment,” said Richard Kollauf, a CPA/CFP at BMO Private Bank in Milwaukee. “If your client earns more than $200,000, the chances [of an audit] go from less than one percent to almost four percent.”

“Recently we’re also seeing triggers such as cryptocurrencies, international filings and past real estate activities,” added Brad Polizzano, senior manager at Baker Tilly in New York. “The IRS audit rate for individual returns was the highest–14.52 percent–for AGI of more than $10 million.”

A return is selected for audit based on a combination of automation and human observation. “The number of audits the IRS is able to perform due to budget cuts requires them to look for tax returns that are most susceptible to a positive tax adjustment for the IRS,” said Scott Kadrlik, a CPA with Meuwissen, Flygare, Kadrlik & Associates in Eden Prairie, Minn.

Though the number of IRS audits fell in recent years to the lowest levels in almost two decades, certain red flags such as excessive deductions (especially non-cash contributions to charities) can often trigger audits. Other triggers include large deductions in general, in comparison to income; large business expenses; an audit of a related return, such as of a business partner; certain kinds of activity in rental property; excessive losses on rentals; or, on a Schedule C for the self-employed, unusual expenses for depreciation, travel or offices.

Risk of audit has historically increased if income is reported that’s not already tied to a reporting form. “For instance, 1099s show dividends, interest, capital gains and so on,” said Douglas L. Smith, a CPA/CVA at RKL LLP in Lancaster, Pa. “What can cause some red flags are sales of non-public stock, business expenses on a Schedule C and rental expenses on a Schedule E. Another area was unusually miscellaneous deductions related to the 2-percent limit on AGI.”

Tax reform did away with some of these categories and deductions.

The IRS compares filings with statistical norms. Returns with anomalies can then be reviewed by up to three layers of IRS personnel before a decision is made on whether or not to audit. “The IRS also uses random audits to bolster validity to their computerized norms. They also use a computer automated process to kick out returns that appear abnormally out of range of a peer norm,” Kollauf said.

Audits begin with a mailed notice–the IRS never calls to initiate an audit–telling your client details of all items the auditor will want to see. Many audits are handled totally by mail; if excessive charitable contributions are the only trigger, for exampe, it would most likely be a correspondence audit, Smith added.

Kollauf added that as many as three-quarters of audits are handled by mail.

What’s an audit process like from your client’s perspective? “Painfully slow,” Polizzano said. “A high-net-worth exam could easily take a year or two. Agents are usually working several dozen cases at a time.”