Have any clients who own a business? How about clients who've made lots of charitable deductions or who earned a lot of income in 2013? They could be facing a higher audit risk as tax season rolls around.
By now, many taxpayers have received their W-2 and are gearing up for April 15, the deadline for filing individual income tax returns. Though there are some typical risks in any given return, the Tax Man has an eye out for certain risk factors and combinations of filing anomalies.
“The IRS sorts returns based on a scoring system, which is secret, but there are some things that will cause them to pay more attention to a particular tax return,” said Janet C. Hagy, president of Hagy & Associates PC and member of the AICPA's IRS practice and procedures committee.
Some of those risk factors are fairly simple:
High income. “If you look at the tracking of audits, once you cross the $200,000 mark in income, you're more likely to have an audit,” said Gavin Morrissey, vice president of wealth management at Commonwealth Financial Network. The risk is even higher for those earning $1 million in income. “It's got nothing to do with deductions; it's just that you've made that much money,” Mr. Morrissey added.
Tax strategies. Other risks tie into the strategies that clients may have used in 2013 to mitigate their tax blow once they filed. Charitable donations, particularly of stock, were all the rage last year because the market appreciated considerably and taxpayers were finding themselves with steep capital gains taxes. The strategy was to make a large gift of appreciated stock and receive a charitable deduction in return. Those tactics can attract the IRS' attention.
Deductions. The IRS tracks the average size of deductions based on the amount of income a taxpayer earns. So deductions that are far out of whack with a filer's income will look suspicious. The advice: Be sure to carefully document your donations, and if you're donating a home or building, be sure to have a qualified appraisal, noted Mr. Morrissey. If the donation is non-cash and valued over $500 — say a bundle of stocks — then the client is required to file Form 8283, which describes charitable contributions of property other than cash.
Charitable donations. Donations of more than $250 in one transaction require taxpayers to obtain a letter from the charity, detailing the gift in order for the taxpayer to claim the deduction. If a client files and gets audited for claiming charitable deductions, it's already too late to chase down any required receipts and paperwork from the charity. “You have to have your receipts in hand; you can't just go running for them when the IRS shows up to audit you,” said Ms. Hagy.
Related: Why charitable giving is on the rise
Entrepreneurs. They will also be subject to extra scrutiny from the IRS. “Running a business in your home is fraught with the opportunity for people to stretch the truth,” said Robert Keebler, partner with Keebler & Associates. “The IRS knows it, and they want to look at it.”
Small business owners run the risk of pushing for business expense deductions when they are really personal expenses. For instance, if an entrepreneur uses a car for his business activity, he probably shouldn't try to claim the entire value of the car as a business expense, Mr. Morrissey said. The same goes for people who aggressively deduct business expenses related to a home office.
While we're at it: Small business owners who report a negative gross profit — meaning that the business sells its products at a cost where it can't recover its own expenses — are “guaranteed to be audited,” said Ms. Hagy.
Real estate. Vacation homes that taxpayers own and sometimes rent out are also on the IRS' radar.
Ms. Hagy warned that filers can't deduct all the expenses on the vacation home. Rather, they need to properly allocate expenses between personal and rental use. “If you rent it for too many days, then there are limits on what you can deduct,” she said. There are also many taxpayers who will prepare their own returns and will fail to note the appropriate number of days of usage as a rental. “That lack of information can be just as damaging as putting in information that creates questions,” Ms. Hagy added.
Also watch out for clients who are moonlighting as landlords. They may want to claim rental losses on their properties, which aren't fully deductible unless the taxpayer meets the IRS' definition of a real estate professional. In order to qualify for those deductions, the taxpayer needs to meet two qualifications: He must spend more than 750 hours a year materially participating in business in real properties and rentals; and more than half of personal services in all businesses for the year must be performed in real property and rental real estate.
“Part-time landlords should be careful,” warned Mr. Morrissey.