10 IRS Tax Audit Triggers to Avoid

4. Rounding or estimating dollar amounts

Another easily avoidable audit red flag is rounding or estimating dollar amounts on your tax return.

Say, for instance, you round $403 of tip income to $400, $847 of student loan interest to $850, and $97 of medical expenses to $100. The IRS is going to see all those nice round numbers and think you’re making them up.

And if you actually make up numbers by, say, estimating your income or expenses, that’s another way to draw unwanted attention to your return. Remember, the IRS is getting information about your tax situation from other sources. If that information doesn’t match what you report on your return, the IRS computers are going to spit out your return for a closer look.

Plus, if you’re rounding or estimating certain dollar amounts, the IRS might start questioning everything else on your return, too. And that could lead to a much more intense audit. Fortunately, it’s easy to avoid this situation — just don’t ever round or estimate dollar amounts on your tax return.

5. Claiming refundable credits

Refundable tax credits can drop your tax bill below zero and generate a tax refund. For instance, if your pre-credit tax bill is $1,000, a $1,200 refundable credit will trigger a $200 tax refund.

On the other hand, the best you can hope for with a nonrefundable tax credit is a $0 tax bill. For example, if you owe $1,000 in tax before applying a $1,200 nonrefundable credit, your tax bill will be knocked down to $0, but you won’t get a refund (i.e., you essentially lose $200 of the credit).

Because they’re often used to obtain fraudulent tax refunds, claiming refundable tax credits on your tax return can increase the odds of being audited. This includes the earned income tax credit (EITC), child tax credit, health insurance premiums credit and American Opportunity tax credit.

For example, as noted earlier, the IRS only audited 0.3 percent of all personal income tax returns for the 2018 tax year. However, the audit rate tripled, to 0.9 percent, for people who claimed the EITC on their return for that year. That translates into more than 150,000 additional audits just for people claiming the EITC.

If you’re legitimately eligible for a refundable credit, then you should absolutely claim it. Just don’t be too surprised if your tax refund is delayed because your return was pulled aside for a closer look.

6. Taking unusually large deductions

The IRS has been collecting taxes for a long time, so it has a pretty good idea of what to expect in terms of deductible expenses for taxpayers at your income level. So, if you claim a large deduction that doesn’t make sense for someone in your income range, the IRS computers are going to flag that deduction.

For example, if you make $50,000 during the year, the IRS is going to be suspicious if you claim $20,000 in donations to charity. While that might be a typical charitable deduction amount for someone with a high six-figure income, it’s quite unusual for people earning $50,000 per year.

But once again, if you do have a legitimate deduction, don’t be afraid to claim it even if it seems high. Just make sure you can back it up with receipts or other documentation if the IRS questions it.

7. Claiming credits you clearly don’t qualify for

One reason the IRS audits tax returns is to uncover tax fraud, such as claiming tax deductions and credits you’re not entitled to. In many cases, the IRS computers can’t tell if you’re claiming a tax break for which you don’t qualify. But sometimes it’s easy to spot.

For example, self-employed people are generally eligible for the home office deduction if they satisfy certain requirements. However, regular employees working from home can’t write off the related costs of a home office. So, if the only income included on your tax return is employee wages reported on a W-2 form, the IRS is going to know that something is wrong if you also claim the home office deduction.

Even if you’ve made an honest mistake in claiming a tax break you’re clearly not eligible for, the IRS is still going to pull your return for further examination. This could ultimately result in your tax refund being reduced or the IRS sending you a bill.

8. Reporting business expenses

If you’re a self-employed sole proprietor (including just having a side gig), your business profits and losses are reported on Schedule C (Form 1040). However, the IRS has learned from experience that many small-business owners aren’t always accurate when it comes to reporting business income and expenses. As a result, the odds of being audited go up if you file a Schedule C with your return.

This is especially true for business owners who typically have a lot of cash transactions, such as cabdrivers, food truck operators, hairstylists and the like. Audits of these types of businesses are often aimed at discovering unreported income.

Self-employed people also have a greater tendency to inflate deductible business expenses, such as for travel, meals, office supplies and the like. So the IRS pays close attention to business expenses reported on Schedule C. Deducting 100 percent of the cost of operating a car or truck used for business is also a sign that something is off, because the IRS knows that the vast majority of self-employed people will drive their vehicle for personal use at least some of the time.

The key for self-employed taxpayers is to keep extremely accurate records of your income and expenses. That way, you’ll be prepared if the IRS questions any of your reported figures.

9. Deducting expenses for a hobby

A related audit red flag is reporting business expenses for something that’s just a hobby , not an actual business. If you’re earning money from a hobby (e.g., making jewelry in your spare time), you can’t deduct the costs associated with that activity (although the income is taxable). So, if the IRS suspects that you’re deducting expenses related to a hobby, you can expect to hear from them.

How do you know if your money-making activity is an actual business or just a hobby? Basically, a business is operated to make a profit, while a hobby is for pleasure or recreation. The determination of whether you’re running a business is made on a case-by-case basis and depends on multiple factors, such as whether you:

• Carry out the activity in a businesslike manner (e.g., keep complete and accurate books and records).
• Put in the time and effort needed to make a profit.
• Actually make a profit in at least some years.
• Depend on income from the activity for your livelihood.
• Have losses that are normal for the start-up phase of your type of business.
• Change your methods of operation to improve profitability.
• Have the knowledge needed to carry out the activity as a successful business.

10. Receiving or selling cryptocurrency

Data collected by the IRS suggests that the noncompliance rate for reporting taxable income from trading digital assets such as cryptocurrencies and non-fungible tokens (NFTs) could be as high as 75 percent. That’s why the IRS keeps a close eye on transactions involving digital assets and is expanding its compliance efforts in the area. In fact, the tax agency considers digital asset compliance a priority for the 2024 fiscal year and recently hired outside experts to help.

There’s also a question at the top of Form 1040 specifically asking if you received, sold, exchanged or otherwise disposed of a digital asset at any time during the tax year. Once regulations are issued, the requirements for reporting certain transactions involving digital assets will be stiffer, too. This is further evidence that the IRS is very serious when it comes to the taxation of income from digital assets.

Expect all this additional scrutiny to result in higher audit rates for people dealing in virtual currencies and other digital assets.