Top 10 Triggers That Increase Your Risk of an IRS Audit

According to Internal Revenue Service (IRS) statistics, the agency processed over 240.2 million federal tax returns in 2020. The IRS typically audits less than one percent of all returns and indicates that it works to ensure that audits are spread across income categories so that there is fairness and voluntary compliance.

The IRS also demonstrates a consistent response to certain actions on federal tax returns – also known as “audit triggers,” outliers, errors of commission and omission that substantially increase the risk of an IRS audit.

Below is a list of the top 10 audit triggers:

1. Filing an S-Corporation Tax Return Without Officer Compensation

If you own an S-corporation, perform more than minor services and receive or are entitled to receive payments, you must report these payments as W-2 wages before any non-wage distributions via Form 1099-Misc or 1099-NEC.

Officer compensation should be reasonable. There are no guidelines in the tax code or regulations, but the courts have determined reasonableness by evaluating the source of gross receipts and the following factors:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of bonuses paid to key personnel
• What comparable businesses pay for similar services
• Compensation agreements
• Formula used to determine compensation

A significant “loans to shareholders” balance in the absence of or a minimal amount of officer compensation will also increase your audit risk.

2. Reporting Expenses in Categories Inconsistent with Your NAICS Business Code

The IRS looks for anomalies. For example, if you’re a songwriter (NAICS Code 711710 — Independent Artists, Writers and Performers) and you take deductions for repairs and maintenance, you’ll need to demonstrate that these are valid expenses.

Let’s say you’ve built a home studio and are now installing a VoIP (Voice over Internet Protocol) line to collaborate with producers or other musicians. You have legitimate deductions for capital expenses. Make sure you include your supporting documentation, such as construction estimates and invoices from contractors and original equipment manufacturers (OEMs).

3. Bad Debt Expense Deduction for a Cash-Basis Business

The IRS generally sees bad debt as an accrual-basis business deduction, as income isn’t reported for a cash-basis business until received. This means the business can’t take a deduction if it was never paid for its goods or services.

When claiming this deduction as a cash-basis business, you want to ensure that the transaction qualifies as a true “bad debt.” Here again, supporting documentation, such as collection letters, strengthens your case.

4. Failure to Report Income — Especially Income on Information Reporting Documents

If you receive a Form 1099-K, 1099-NEC, 1099-Misc or Schedule K-1 and don’t report income, you’re risking closer scrutiny. This is because the IRS can match all third-party documents. Each information reporting document has a Copy A, B and C. Copy A goes to the IRS, which they then use to reconcile your tax return. Therefore, make sure you have received and included all income reports.

5. Reporting “Salaries and Wages” and Contract Labor Without Filing the Appropriate Information Reporting Documents

If your business pays employees and independent contractors, but doesn’t file W-2s, 1099-Misc or NEC forms, you shouldn’t expect that omission to go unnoticed. If you’ve made any of the following payment types to an individual for at least $600 during the calendar year, you must file an information document report covering:

• Services performed by a person who isn’t your employee
• Cash payments to purchase fish from anyone engaged in the business of catching fish
• Payments to attorneys, including law firms or other legal services providers

You must also file a Form 1099-Misc for anyone you paid during the year, including but not limited to the following:

• Rents
• Royalties
• Other income
• Federal tax withheld
• Fishing boat proceeds
• Medical and healthcare services
• Substitute payments in lieu of dividends or interest
• Crop insurance proceeds
• Gross proceeds paid to an attorney

In addition, you must file a Form 1099-NEC for anyone whose federal income tax you withheld under the backup withholdings rule, regardless of the amount of payment.

6. Deducting Ordinary Losses and/or Distributions from Partnerships and S-Corporations in Excess of the Owner’s Basis

Many business owners mistakenly believe that if Schedule K-1 has an ordinary loss, they can then automatically deduct the total loss on their Form 1040. Deducting the total loss in the current year may not always be accurate. The deduction of pass-through losses on your individual Form 1040 must not exceed your individual basis in that entity.

Track your individual basis on a basis worksheet, making sure that your losses and distributions don’t exceed those amounts.

7. Lumping All Expenses in “Other Deductions” and Not Reporting Expenses Based on Their Category

You must be specific when reporting expenses and assign them to categories, such as “Advertising” or “Supplies.” Lumping your expenses in “Other Deductions” can significantly increase that total compared to gross receipts, which may be an outlier in your business activity.

Avoid unusual and unsupported deductions to reduce the likelihood that the IRS will want to take a closer look at your return.

8. Significant Fluctuation in Increased Expenses Compared to Prior Years

If your business has maintained a consistent level of gross receipts, but year-over-year expenses are up, you may be raising questions you don’t want to answer. Your gross receipts set a baseline for expenses that the IRS will deem reasonable.

9. Reporting Losses Year After Year

The IRS looks for high-income taxpayers reporting substantial business losses on Schedule C of their Form 1040 year after year. They take particular interest when these deductions offset other forms of income. The IRS considers nine factors to determine if the taxpayer’s business is for-profit or a hobby:

• The manner in which the taxpayer conducted the activity.
• The expertise of the taxpayer and his or her advisors.
• The taxpayer’s time and effort in conducting the activity.
• The expectation that assets used in the activity may appreciate in value.
• The taxpayer’s success in other similar or dissimilar activities.
• The taxpayer’s history of income or loss with the activity.
• The amount of occasional profits earned, if any.
• The taxpayer’s financial status.
• Elements of personal pleasure or recreation.

The IRS notes that no single factor is decisive in their “profit versus hobby” determination, and they must consider all facts and circumstances. In addition, the agency notes that “the mere fact that the number of factors indicating the lack of a profit objective exceeds the number indicating the presence of a profit objective (or vice versa) is not conclusive.” The courts have given more weight to objective facts than to taxpayer statements of intent.

If you run your activity in a business-like manner with a reasonable expectation of profits, the IRS may not contest your deductions. If not, you may have to settle the matter in the Tax Court. The IRS has a winning record in these cases, as it tends to settle the ones it doesn’t expect to win. Taxpayers prevail on occasion, but they have supporting documentation for all expenses.

10. Filing a Tax Return Inconsistent with Your Filing Requirement

If you filed an election to be an S-corporation filing Form 1120-S, then you shouldn’t file a C-corporation tax return using Form 1120.

If this happens, the IRS will remove Form 1120-S tax returns from processing if the taxpayer’s account doesn’t note a Form 1120-S filing requirement. They’ll also remove Form 1120 tax returns from processing if the taxpayer account has a Form 1120-S filing requirement.

The IRS considers these filings as “unpostable,” meaning they can’t be processed. Unpostable returns go to tax examiners for review and correspondence with the taxpayer.

Bonus Audit Trigger — Large Net Operating Loss (NOL) Carrybacks

The IRS has to focus its audit efforts where they’re most likely to recover tax payments. Thus, they may zero in on net operating losses (NOL) carried forward to offset current tax year income.

The Tax Court has proven remarkably unsympathetic to taxpayers who lack the records to document their losses. The following are established as the standard of proof to claim NOLs:

• The burden of proof rests with the taxpayer, who must substantiate NOLs with documentation and the carryover amounts.
• Taxpayers must “show their work,” providing supporting documentation with their return that defines the NOL, all relevant facts and their computations.
• In addition, the taxpayer’s claim must show an NOL for one tax year before the current tax year and proof of election to waive a carryback of that NOL. Failing that, the taxpayer must show whether the NOL was carried forward.
• The taxpayer must also demonstrate that the NOL couldn’t be applied against income for tax years immediately following the year of the NOL.

Ultimately, the Tax Court wants to see substantiation. This means prior tax returns showing a consistent approach to NOLs and comprehensive documentation.

The Value of a Meticulous Approach to Risk

The IRS does conduct fewer audits than in previous years – in fiscal year 2019, the IRS audited less than 0.5 percent of all individual tax returns. Today, the IRS says that “generally it will not open new examinations during the COVID-19 pandemic unless the statute of limitations is expiring.”

If you plan to take an aggressive stance on your taxes, remember that the best offense is an unimpeachable defense. This means accurate, complete returns and documentation to substantiate all expenses and deductions.

To discuss your taxes and how to minimize your audit exposure in a rational, defensible manner, reach out to your Windham Brannon advisor or contact Tomika Bullet.