How to “guarantee” an IRS audit

Ben (00:05):

Welcome back to the Retirement Tax Podcast. I’m your humble co-host, as always, Benjamin Brand. Joining me today, Steven Jarvis. How are you doing today Steven?

Steven (00:13):

Ben, I’m doing really good.

Ben (00:14):

So we played, I successfully won the stump the CPA challenge a few episodes ago, so I wanted to take my chances again and I ran across, this is question from a financial advisor that I found in an online forum, and since I filed an extension this year, I wanted to run this by you to see if there’s any substance to this question. So advisor writes, I heard from an older CPA that late filing has a lower chance of being audited because the IRS samples based on the period of return, so let’s say April 15th, the original filing period. So the logic is if I wait to file until October 15th, I’m less likely to be audited because the IRS took their sample in April to fill up 90% of their slots, and there’s just not as much attention for audits. If I wait and file for my extension, so does that hold water and should I file an extension for the rest of my life and never get audited?

Steven (01:09):

I love how much time people spend trying to figure out the inner workings of the IRS because I often tell people, you got to stop looking for the logic, and the tax code and with the IRS because there is none. Specific to this question, I’ve been doing this for a while in a variety of shapes and sizes of firms, and I have never seen a CPA take the strategy of let’s extend all of our clients so that they don’t get audited. It’s a nice thought, but the IRS, they’re not very forthcoming about their approach to how they choose who gets audited. And so while I can’t officially refute and say that there’s no truth to that, my experience would tell me that no people are not out there intentionally extending their returns just to lower their chance of getting audited. If you need to file an, we’ve talked about that on the podcast before, there’s nothing wrong with filing an extension if you need the additional time. There could be some different reasons to do that, but I personally would not recommend extending just on this off chance that your audit risk goes down.

Ben (02:15):

Well, Steven, you’ve said this in the past, every line item, every credit or deduction, there’s a lobbying group behind that, and I assume there’s an incentive behind that. So if the IRS was publishing that you’re less likely to get audited in October, wouldn’t everybody that doesn’t want to get audited, wouldn’t the incentives be there to file? I mean, I would assume the IRS would want to show their hand like that because then bad players are just going to go do that thing, right? I mean, does that make sense?

Steven (02:42):

Yeah, it does make sense. I think that’s a lot of the logic behind why the IRS doesn’t publish more about how they choose who gets audited is. Yeah, because then we’re all going to change our behavior, right? Actually, Ben, especially since we just took a road trip together, one of the analogies that always comes to mind is I ask people how they approach speed limit because I mean, so I was driving from Spokane, Washington to the Black Hills of South Dakota, and you get out on the freeway on the speed limit between here and there either says 70 or 80 through parts of Montana. And so you’ve got to make this choice of what are you going to set your cruise control at? And I get a lot of people who will then compare that to the tax code of, oh, well sure, the speed limit says 80, but they’re not going to pull me over if I’m going under 85 or there’s whole stretches of Montana where I mean, are there even police there?

(03:29):

So why don’t I go 90? You’ve got all these different trains of thought. And while I can tell you that my cruise control was not set at exactly 80, I can also tell you that my approach to the speed limit is very, very different than my approach to the tax code because the tax code was not written as a bunch of suggestions for you to get close to. There are some subjective areas, but in general, if I ever am in the unfortunate situation of sitting across the desk from an IRS agent, I don’t want to have to say, oh, well we got close. I want to be able to say, here’s what we chose to do and why and have the documentation to support it.

Ben (04:06):

So in a recent episode, you talked about the straight face litmus test, so we could apply that to the highway patrol. When the officer walks up to your window and he asks, do you know how fast you were going? Could you respond with a straight face of, I think I was going 80, maybe a little bit under, but the same applies for the IRS agent. Is that right?

Steven (04:22):

Yeah. Again, I don’t love the, I get why people bring it up, but it is just not the same thing. It just really isn’t. Not in practice and not in reality. But we do get lots of questions about it. I mean, similar to this question that got brought up on that forum, and it’s not that hard to find examples where there’s plenty of interest in this. In preparation for this episode, I knew that you had a question in this vein, went and found dozens of articles that talk about, okay, here are all the reasons you might get audited, the things to avoid. And so I picked one from Kiplinger earlier this year that went through 19 different audit red flags. And so I want to talk about some of these just so that we can keep good perspective on how we make decisions about what goes on our tax return.

Ben (05:07):

Okay, I’ll run through these and then you tell me what you think. The first one I recognize, failing to report all taxable income. So what’s interesting about filing taxes is you get all of these 1099s and things like that in the mail, but they don’t just send those to you. You’re not the only person that is in possession of that information. So if you leave a couple off, eventually that’s going to come around. It could be years, but eventually that’s going to come around and the IRS is going to give you a friendly reminder that they have this information too and they’d like you to settle up. Am I the only person that gets that 1099 or are there other people that get it?

Steven (05:37):

No. Lots of people get that. Same with W2, same with a lot of tax forms. And the interesting thing is that the IRS doesn’t even have to audit you in that case, they send you a mismatched letter and they just say, Hey, we know you had more income, so here’s the taxes that you owe, Ben. You’ll see that a lot of these come down to we need to pay every dollar we owe. We just don’t want to leave a tip. So while I am glad that we can go through this list and give some context, most of this is going to come back to pay the taxes you owe and keep good records

Ben (06:07):

And keep good records. Yeah, I don’t remember what I had for lunch last week. I’m certainly not going to remember what my exact income was or the exact interest I under my checking account four years from now. So keep those good records. When your accountant hands you back that folder, don’t hit it in the shredder. Keep that information. How long should we keep it for? Is it seven years?

Steven (06:25):

That’s good rule of thumb.

Ben (06:26):

Good rule of thumb. Seven years. Okay, so next red flag, making a lot of money in and of itself. Is that a red flag, Steven?

Steven (06:32):

So this one’s interesting because there are some statistics that back this up that as your income goes up, your risk of audit goes up as well, but we need to keep this in perspective even as your income goes up, that doesn’t mean now you have a 50-50 shot of getting audited even at a high income level, however you want to define that, whether that’s 200,000 a year, a million a year, everybody has different definition of what high income means. Yes, the statistics will back up that your chance of audit does increase, but it’s still very, very small. And I have never run across a situation where I would even consider telling a client, Hey, you should probably think about making less money because you might get audited because an IRS audit is not going to be fun. Let’s not kid ourselves, no one’s going to volunteer for it. But if you are filing your tax return correctly and you’re keeping good records, an audit doesn’t have to be this scary, terrifying thing.

Ben (07:28):

I suppose that passes the logic test, right? If you have a smaller income, if your total tax liability is $2,000 for them to set an auditor your way versus your total tax liability of being a hundred thousand dollars, there’s just a lot more juice for the squeeze to pursue a higher income individual. And maybe higher income individual has more deductions or more credits or more sources of income, more opportunities to make a mistake or to maybe fudge the numbers and thus more likely to get audited. Does that kind of passes the logic test? Right?

Steven (07:59):

So actually there is some logic behind the IRS does have metrics on their recovery rates, right? I mean, so while the IRS is a branch to the government, they still have expenses and they are kind of monitored on how much are they actually, when they go and do these audits, how much are they actually collecting? But that doesn’t play out always in the ways you might expect because the other trade-off that you have is that as people have more income, they also have more ability to fight legal battles. And so whether you’ll get somebody to admit this or not, there’s been a lot of investigative reporting that has shown that there’s kind of this trade off of the IRS in years past has actually spent inordinate amounts of time auditing like the earned income tax credit, which is for low income individuals, but because those are people who can’t fight them very hard, they’re able to recover at a high rate. And so I guess we’re kind of skipping to the end here of one of the points that I make anytime this topic comes up is that we shouldn’t be making tax decisions based on whether or not we think we’re going to get audited. If you’re making your tax decisions hoping that no one notices you’re doing this the wrong way, we want to make the right decisions based on the information available to us based on the rules available to us, and we want to keep great documentation.

Ben (09:14):

Very interesting, very interesting. So the next red flag is non filers. So to me that is a big red flag. If you go from filing your and you haven’t passed away, if you go from filing to not filing and then back to filing, I would imagine it’s a pretty big red flag.

Steven (09:27):

Yes, absolutely. Let’s make sure we file our taxes every year.

Ben (09:31):

Moving on, taking higher than average deductions, losses, or credits. So if you’re right out of the blue, if your deductions go way up, that might be a red flag to the IRS.

Steven (09:41):

Yeah, and this is also relative to your income to other things on your tax return, if for the last 10 years you’ve reported a hundred thousand dollars of W2 wages, and then suddenly you report $2 million of charitable deductions. Those are things that stick out. The IRS uses computers to flag some of these things. Even a computer’s going to identify that. That looks a little odd. The one reminder I like to give with this is that if we have the documentation to support what we’re doing, we should never shy away from taking legitimate credits or deductions just because we think it might raise a red flag if we have the documentation to go along with it.

Ben (10:17):

So along that similar vein, taking large charitable deductions might be a red flag for an audit.

Steven (10:22):

Again, anytime the IRS sees things out that are out of the ordinary, yes, there’s so many tax returns filed every year, they’ve got to be able to use software to flag different things. And so having any line of your tax return that looks out of the ordinary could slightly increase your chances of getting audited. But we’re still talking about the chance of any of us getting audited as being very, very small. We want to make the right decisions, keep good documentation. I’m going to come back to that over and over again.

Ben (10:52):

Speaking of documentation, running a business could be a red flag for an audit.

Steven (10:57):

Yes. So again, there are statistics that back up that the business owners, especially self-employment income schedule C type income is at a slightly higher risk for getting audited. And then there’s a couple of things that run together on this list of things that might increase your risk for audit. So yes, having a business, I mean back to taking higher, higher than average deductions, that is also applicable when we’re talking about what we’re deducting against a business, one that comes up sometimes is referred to as Hobby loss rules, where the IRS will basically say, wait, do you actually have a business at all or are you just trying to run your personal expenses through here? So some things to look out for is if you are riding off business expenses but you’re never generating income, that’s a really easy red flag for the IRS that they’re going to come back and potentially disallow those expenses.

(11:44):

Another piece that goes with that is making sure that if you have business income, that you’re correctly reporting it as self-employment income. This is a great reminder that just because software will let you do something does not make it correct. And so as you go through the prompts, especially in a DIY tax preparation software and you have 1099 income, you have self-employment income or business income consulting, whatever it might be, you’re going to get to a spot where it’ll just ask you, is this subject to self-employment tax or not? And it is just a simple question. And so you can mark, no, this isn’t subject to self-employment tax and the tax return’s not going to calculate self-employment tax for you, but that doesn’t mean it was correct. Your return might get accepted and filed just fine. That doesn’t mean it was correct. And so there’s several things related to businesses that can potentially increase our audit risk

Ben (12:36):

There. And so in layman’s terms, that’s asking me whether or not I should pay payroll tax on this self-employed income. Is that right?

Steven (12:42):

Yes, it is. And so again, when you’re going through especially a DIY software and one option increases your tax bill and one option doesn’t increase your tax bill, and you can pick either one, probably well-intentioned people are going to say, oh, well, I don’t think this should make my tax bill go up, but that doesn’t make it right.

Ben (13:00):

Tell me about claiming rental losses. How does that make more of a red flag for the IRS?

Steven (13:05):

There’s a lot of things related to real estate that kind of rubb the IRS the wrong way because there’s some very nuanced rules around real estate that people tend to abuse. And so one of them relates to think of this as I’ve got my regular employment, but I’ve got a rental property on the side because everyone on TikTok tells me I need to be involved in real estate. So I get this rental property. And quite often for tax purposes, especially in the initial years of having a rental property, you’re going to have taxable losses because we get a claim depreciation, there’s all these expenses, we could have a taxable loss, but the IRS considers that to be passive income and there’s restrictions on using that passive income to offset my regular income. But there’s ways around that if you are considered to be an active participant or a real estate professional. And that’s where things can get a little bit shady, that people again will just check a box and say, well, of course I materially participated. Of course I had 500 hours of active participation. There’s some different guidelines there. And again, just because you can check the box doesn’t make it true. And so that’s an area where the IRS has time and time again. One case is against people who were claiming real estate professional status when they had no business doing that.

Ben (14:18):

Okay. How about claiming the American opportunity tax credit? I’m an American who loves opportunities. Can I just take that credit?

Steven (14:25):

Yep. So this is one of those, again, I wish the tax prep software was a little bit more sophisticated in what it would prompt you to do or not do. This is related to education expenses and there’s several different rules about who qualifies and when they qualify. And so I think, again, this falls in the bucket of ones that the IRS will go after because it’s really easy to prove that you incorrectly claimed it and that they’re going to be able to recover it. So this shouldn’t scare you from taking the credit if you are eligible for it, but let’s not get carried away just claiming credits. We think it might be nice.

Ben (15:01):

Okay. How about incorrectly reporting the health premium tax credit? That’s if you’re getting some help from Uncle Sam to pay for your health insurance, presumably you bought it through the affordable character website and things like that?

Steven (15:13):

Yeah, so the premium tax credit, the PTC, this can be potentially very lucrative. This one’s also can be a little bit more complicated because when you go and get your insurance on the marketplace, it asks you to project your income ahead of time. And so again, you can put anything you want. So you can say, I’m only going to have $10,000 of income, which will skyrocket the amount of your credit that they will then prepay to you. And then when it gets to tax time, then now you have to settle up and say, oh, wait, no, I actually had $200,000 of income. I wasn’t eligible for any of that. And so again, when we screw around with credits, we’re definitely going to increase our audit risk, but if we’re legitimately eligible and we have the right documentation, we should do it every time. I’ve never sat down with a client and said, you know what? Let’s not take that credit that you’re eligible for just because it might increase our audit risk.

Ben (15:58):

Right? Pay what you owe, but no gratuity, I suppose. Take all the credits that you owe, take all the premium assistance that you open, but no gratuity. So when you are filling out the paperwork at the affordable care site, guesstimate your income correctly, you’ll get a much larger assistance with your premium if you say it’s low, but you’ll probably end up paying that back and they want it all at once. So that can be pretty tricky. Moving on here, taking an early payout from an IRA or a 401K, is that a red flag for audit?

Steven (16:23):

So what’s interesting to me about this list, and I mean this is no criticism to Kiplinger or whoever wrote the article, but again, the IRS does not specifically publish. Here’s our audit methodology. And so some of this is a little bit of guesswork, and so I have never worked with a client who’s been audited because they took an early payout from an IRA or a 401K. I think part of the reason this is on here is because there can be some additional penalties and taxes. If you take an early payout, and again, in the tax prep software, you can just click a button and say, oh, wait, that penalty didn’t apply to me. That doesn’t make you right. And so again, where the IRS thinks that they can easily recover taxes that are owed to them, those are things they’re going to go after. So it still comes back to make sure we have good documentation and let’s do the right thing.

Ben (17:08):

Yeah, that’s an interesting one because I suppose I could take a distribution from my 401k, I’m not yet 59 and a half. They will probably mandate that I do a 20% withholding, but that doesn’t necessarily mean that’s all the bill that I’m going to owe because I’m going to owe 10% plus my income. So my income with a 10% could be under that 20% could be over withholding or it could be significantly under withholding. And if you’re not savvy, like you say, if the softers ask you the question, you could say, I don’t think that 10% applies to me and I assume probably why it’s on this list.

Steven (17:37):

Yeah, because there are some reasons that you can get an exemption to that 10% penalty and when you’re filing the tax return initially, it literally, okay, great. Check the box. It doesn’t apply to me, but we got to make sure that’s really the case.

Ben (17:48):

Okay. Moving on here, reaching the end of our list, you’re taking an alimony deduction. Does that put us at more risk for an audit?

Steven (17:56):

So alimony is an interesting one because the rules changed several years ago now. So the rules were different prior to 2019, and then after 2019, and so since 2019, or sorry before 2019, under very specific circumstances, alimony was deductible if you were the one paying alimony. But so we’ve got to be paying attention to the dates involved and to our specific circumstances. And so this is one that if it’s relevant to you, you want to double check the information. But again, a lot of this comes down to I can type whatever I want into a form, and if I know that typing, even if my divorce didn’t happen until 2020, but I know that if I type 2018 into the date it started that I’m going to get a bigger deduction. Turns out people are going to type that every time. And so the IRS cracks down on these things where it’s self-reported, but needs to happen a very specific way.

Ben (18:47):

This one reminds me of our earlier example where we can mark that we are a professional in real estate and thus we can take additional deductions. Can I mark that I’m a professional gambler and then write off winnings or losses in my gambling career?

Steven (19:02):

This one’s a little bit different because it’s not a matter of whether you’re a professional gambler. The way the IRS rules work is that you can only deduct gambling losses that offset gambling winnings. And so what will happen is that people will have a gambling winning, whether this is the lottery or they hit it big on the slot machine or whatever it might be, and they’ll say, well, of course I had more losses than I had winnings. I’m at the casino all the time. Of course I had that much in losses. But of course, it’s not a valid argument to the IRS. We actually have to document when we’re playing, how we’re playing, how it was paid for, all of those things. Because if the IRS ever comes and asks us questions, they are going to ask for that information and just saying, well, I go to the casino every Friday, that’s not going to cut it.

Ben (19:46):

Okay. Tell me about claiming the foreign earned income exclusion. Is that a red flag? What is it and is it a red flag?

Steven (19:52):

Yeah, so there’s a couple of things on here related to foreign income and foreign assets. This is an area where across the board I tell people that if you have foreign tax considerations, this is probably time to consider working with a professional. And honestly, it is not even something I regularly do. And so I’m not even just looking for work for myself because if you come to me with a complicated international tax issue, I’m going to help you find somebody who does that all the time because now we’re not only worried about the IRS’s tax rules, now we’ve got international tax treaties involved. And so yes, this is a much more complicated area and one that’s much more likely to prompt questions.

Ben (20:27):

So more complexity prompts more questions. Is that kind of a through thread here on what we’re talking about today? 

Steven (20:33):

That tends to be the case, especially when the complexity is self-reported or subjective.

Ben (20:38):

Okay. Well, something that we can’t do in North Dakota, but you can do in Washington, operating a marijuana business is something that now suppose that is the confluence of state regulations being different than federal regulations and then banks are regulated federally. And am I on the right track as to why this would be an audit risk?

Steven (20:56):

Yes. You’re spot on. Yes, Washington has legalized it now for a few years, but it’s still federally, it’s not permissible. And so this is a huge area of concern for people that are in that industry. Not one I spend a lot of time in, so not much more I can say to it other than if you’re going to start any sort of business, make sure you understand the regulations involved.

Ben (21:18):

How about being under the influence while I fill out my tax forms? Is that higher audit risk?

Steven (21:22):

Probably only because you’re more likely to make mistakes.

Ben (21:25):

Okay. That sounds good. How about taking the research and development credit, the RMD credit, this is something that we see a lot on influencers, social media and things like that. People, they’re handing out RMD credits like candy according to social media.

Steven (21:38):

Social media can definitely get you in a lot of trouble. This is another area where the RMD tax credits can be very, very lucrative. These are typically applicable to businesses. A lot of times businesses in the tech and pharma industries, areas where a lot of time can be spent before we ever know if you have a viable product. And so they can potentially be very, very valuable. A lot of subjectivity, a lot of analysis that goes into this. And so there can be a lot of abuse. And when the IRS is potentially shelling out millions of dollars in credits, they want to make sure it gets done right.

Ben (22:10):

Okay. And I don’t remember what year this started showing up, but I feel within the last two years or so, I noticed a box on my 1040 where I’ve got a check box if I’ve had any buys or sells or anything with digital currency. So is this a red flag engaging in virtual currency or other digital asset transaction? We’re talking Bitcoin Dogecoin, all the, it was a big hub hub in 2021. I think it’s faded a little bit since then, but…

Steven (22:35):

Yeah, again, we’re at the end of the day, we’re kind of guessing what the IRS is or isn’t going to do, but they clearly are very interested in this area. That’s why it’s at the top of your tax return. That’s why they’re asking the question. One of the things I’ll say on this, it’s not an area that I spend a lot of time on, but again, so many things, it comes back to the documentation and really where you’re at bigger risk from the IRS’s standpoint is when you’re doing derivative and very complicated things around digital assets. If you have a Coinbase account that’s going to report, that’s going to give you a 1099 every year and report it to the IRS from a tax perspective, it’s like you’re trading other stocks. You’ll have to talk to your investment about advisor, about whether you should be in digital currency at all. I won’t opine on that, but it’s when you get into the really speculative things that might not be being transacted on a reputable exchange that you can definitely get yourself in trouble.

Ben (23:26):

And I’m a little bit out of my element here, but also looking at wash sale rules and things like that. I think a lot of people got in trouble with trading the currencies and not understanding if they were securities or not and how they would potentially be taxed. So there is based on articles that I read, a lot of people that thought maybe they made a small profit or a small loss, but all of those transactions added up and maybe didn’t wash each other out.

Steven (23:48):

Yeah, it’s definitely not a simple area.

Ben (23:51):

And then finally we’re going to bring it home with failing to report a foreign bank account. Is that a red flag, Steven?

Steven (23:57):

Yeah, and this really goes beyond just the IRS because fencing gets involved in this as well. And so if you have $10,000 or more in a foreign bank account, you’re required to report that every year on a form that’s called an F bar, and that’s whether you have income coming off of it or not. And so I see this quite often with clients who have accounts in Canada, and you’ve just got to remember that you having foreign assets is something you’ve got to report to the IRS, and the penalties do start to stack up. If you haven’t been reporting and it comes up in a future year that you haven’t done this for a decade, the penalties start getting pretty steep. So it’s something we want to pay attention to.

Ben (24:38):

It’s specifically mentioned bank accounts, but are we talking Canadian pension, Canadian style, 401K? Are those all kind of included in that same general idea?

Steven (24:46):

Yep. So yeah, this is $10,000 or more of assets held in a foreign country.

Ben (24:50):

Okay. Excellent. Well, thank you, Steven. I feel like I am more knowledgeable about whether or not I’m going to get audited based on those 19 items. I appreciate you shedding some light on those for us.

Steven (25:01):

Yeah, of course. It’s always a pleasure, Ben, for everybody listening, until next time, don’t forget to not let the tax man hit you where the good Lord split you.

Steven (Disclaimer) (25:11):

Hi everyone. Quick reminder before you go. While Ben and I feel very strongly about the information we’re sharing on this podcast, it is for educational purposes only and should not be taken as specific tax, investment or legal advice. You need to make sure that you are working with a professional to evaluate how these concepts apply to your specific situation before you take action.