The color red has a variety of different meanings. If you’re driving your car and the stoplight is red, that indicates you should stop your car. If you’re cooking on an electric stove and the stovetop is red, that means the burners are hot (don’t touch them). In the accounting world, we use the term red flag when there is concern over a business’s (or an individual’s) financial reports.
Dictionary.com defines a red flag as: “a danger signal.” A red flag usually isn’t a good sign, and it’s something that should cause you or your company to stop and pay special attention to that specific area. There are a variety of red flags – some more serious than others. Some could mean that fraudulent activity has taken place, but others could mean that your company needs to report an area differently to maintain compliance.
10 Common Audit Red Flags
If red flags are raised, you may be at risk for an audit or tax notice from the IRS. Here are some common red flags to be aware of and watch out for:
- Reporting inconsistencies. The IRS compares all the forms that your business submits to them with your business’s Form 1040. If there are inconsistencies between the forms, it will likely generate a tax notice or audit.
- Reporting low income. If your tax forms show that you’re making significantly lower income than others in your profession, the IRS may have reason to believe that you’re not reporting all of the income you’re bringing in.
- Using round numbers. If you report rounded numbers versus actual numbers, the IRS may have reason to suspect that you’re not accurately reporting. For example, the IRS probably knows that your business mileage on your schedule C was not 15,000 miles. If you’ve used round numbers in the past, start keeping track of and documenting all of your business trips and mileage.
- Claiming high charitable donations. You can’t fool the IRS! The IRS has a good idea what the average person in each tax bracket donates. If you claim amounts above this average, you may be flagged to be audited.
- Reporting high income. If you report an income upwards of $100,000, you’re much more likely to be audited than those who make less than this amount.
- Having inconsistent federal and state tax returns. If your federal and state tax returns don’t match up, then this may cause you to be at risk of an audit or tax notice.
- Having drastic changes in income. Did you have a $10,000 jump in income in the last year? Then this might raise a red flag to the IRS.
- Reporting high itemized deductions. If you report several high itemized deductions on your tax forms, then you might be in for an audit. This could raise a red flag for the IRS. As it relates to your income level, the IRS knows what the average taxpayer in your tax bracket gives to charity, pays in real estate taxes and mortgage interest, pays for medical insurance.
- Being self-employed. Simply put, if you’re self-employed, this opens you up to a possible audit. The IRS knows there is more of an opportunity for claiming personal expenses or deducting a “hobby loss” – an activity that is presumed to be for profit it income exceeds expenses for three or more out of five consecutive years.
- Reporting excessive entertainment deductions.
While these aren’t the only red flags that may cause you to be audited, these are the more common situations to watch out for.
This article was originally published in Illuminations: Facts & Figures from people with a brighter way, a Rea & Associates enewsletter, 5/7/2014.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.