What Could Get Your Tax Return Audited? Here's What to Watch Out For

Marcy Tolkoff, JD

February 25, 2020

Edward Alter, MD, a 50-year-old psychiatrist, had long deducted home office expenses in his Manhattan apartment. But when he decided to reduce his working hours, he converted the office space into a living space for family use. (The psychiatrist asked that we not use his real name.)

Something in his tax return triggered IRS interest, and an auditor visited his apartment to see the home office for which he had previously taken the deductions. Luckily, the psychiatrist had taken "before" photos of the home office when he used it to see patients. The auditor was satisfied the space had been used exclusively for business purposes and that it satisfied the home office standards for the tax year in which the deduction was claimed.

Had Alter not had the photos and had the deduction been disallowed, he could have been subject to additional tax, interest, and penalties that could have amounted to several hundred dollars or more.

"Whether the inquiry was random or the home office deduction made the IRS' eyes open wider, very often, the IRS' decision will turn on how well you can prove your case with a combination of supporting documents and, sometimes, plain old common sense," explained the psychiatrist's accountant, Stacy L. Gilbert, CPA, an auditing and tax partner at Citrin Cooperman & Company, LLC, Livingston, New Jersey, and New York City.

The IRS is auditing far fewer returns than in years past — just under a million in 2018, vs 1.7 million in 2010 — owing to a cost-cutting reduction in the number of enforcement agents. But that's little solace if you're one of the million who is called on the carpet.

As your income goes up, the odds of your return attracting attention increase, because the IRS generally follows the money and is targeting those who can pad the coffers. Also, the returns of higher-income individuals tend to be more complex, which means there's a higher likelihood of errors — and greater potential tax consequences could dial up the temptation to "fudge" the figures. Think a number here or there can escape notice? Think again.

It's Not Smart to Try to Fool Uncle Sam

In 2018, 140.9 million tax returns were filed from January 29 to May 4, according to the treasury inspector general for tax administration. Every single one is scrutinized each year by the IRS' computers with algorithms that are programmed to detect anything that isn't "kosher," such as a discrepancy between what's on your return and what others, such as your employer, client, or ex-spouse, have reported (as much as you and your ex-spouse may love your children, the IRS doesn't permit both of you to claim them as dependents).

Try at all costs to stave off this kind of attention. Not only can an IRS inquiry cause you angst that has you reaching for an anxiolytic, it can be financially painful as well, because of interest on the additional tax owed, along with penalties that are levied to discourage future noncompliance. In extreme cases, the IRS can garnish wages, put a lien against your house, or even charge you with fraud.

Here are some important ways to boost your chances of staying under the radar.

Report all of your income.

When it comes to income earned, the IRS reconciles the data it receives from you with those it receives from the following:

  • Your employer — If you're an employee, say, as a hospitalist, the hospital is required to send you a W-2 form for your annual earnings.

  • Your clients — Let's say you are an independent contractor with a side income — perhaps as a doctor on call for a corporation — your clients need to supply you with a 1099 form to show your annual earnings.

  • Your partnership or "S" (small business) corporation — Your share of the income should be reflected in a K-1 form; if it's delayed, reach out to the partnership to get an estimate of the earnings allocated to you so you can calculate the correct amount for your personal extension.

  • Your brokerage firm or other financial services company in which your investments are held. This information includes interest or dividend income earned on investments (domestic or foreign), in which case you'll receive a Form 1099-INT or 1099-DIV (or a 1099-B for sales of securities) at the end of the year.

If the sets of numbers don't match, your return may be flagged for further review, even if there was no intent to shield income.

"I had a physician client who bounced around to five different clinics, earning self-employment income," explained Aaron Martinez, CPA, an enrolled agent and H&R Block master tax advisor in Los Angeles. "He needed a 1099 from every single clinic, but it was hard for him to keep track. Also, some of these were pop-up clinics that weren't diligent in sending all the proper paperwork to their contractors." This situation could have created problems for the physician, even if he was not at fault.

Be prudent when taking tax deductions.

Taking so many deductions that your taxable income is cut to ribbons or claiming deductions for expenses that aren't allowed will likely put you under a microscope. Here are some areas likely to draw attention.

Business expenses. Think like an IRS agent. Step back and ask if the deductions make sense relative to your income, to your previous years' returns — and to what's standard in your industry. The IRS has codes that set the standard for what is typical of business expenditures in various occupations. If yours are way out of the norm, you're raising your audit risk.

The rule of thumb is that an allowed business expense must be both ordinary and necessary for you to do your job — unlike Claire S., a 16-year-old actress who is one of Gilbert's clients. She took the liberty of deducting the cost of all of her clothing as a business expense, thinking the expense was necessary to present a certain public image. The IRS said, "Not so fast." It said the cost of the clothing was not an ordinary and necessary business expense. Unlike, for example, a theatrical costume, it was the same type of clothing that anyone would and could wear in public, and the cost was not a legitimate business deduction.

Similarly, many professionals falsely assume that they can deduct the cost of their business attire. Physicians who are employees are no longer permitted to deduct the cost of scrubs, medical journal subscriptions, meals, entertainment, etc that was not reimbursed by their employer. Under the Tax Cuts and Jobs Act, which became effective in 2018 and will be in place through 2025, all those deductions have been suspended. (Keep all your receipts and records regardless, notes Martinez, as you may be able to deduct those expenses on your state tax return.)

Sole proprietors (including single-member limited liability companies) may deduct all ordinary and necessary business expenses, in which case those scrubs and subscriptions could be deductible. If you form a partnership or corporation, the expenses are deducted at the entity level. These entities would also protect you on a personal level from certain liabilities.

There are advantages and disadvantages to the different types of entities, so you should speak to your tax advisor to determine the one that's best for you. Keeping your business reporting separate from your individual tax reporting might not only keep you more organized but could entitle you to deductions that you could not take advantage of just because you didn't have the records to back them up.

One area that often draws attention to a tax return is the deduction for a home office, as in the case of the aforementioned Dr A. "The IRS strictly defines a home office as an area of your home that is exclusively used for business purposes," explained Gilbert. "If there's a large flat-screen TV in your office, that will certainly raise questions."

Follow the law but don't leave money on the table, is Martinez' overarching guidance. "We don't want people to be afraid to take deductions — do it to the extent you're allowed."

We don't want people to be afraid to take deductions — do it to the extent you're allowed. Aaron Martinez, CPA

If you can support the argument that the deduction is reasonable, press the issue, as Gilbert did in the case of a 60-year-old hotel owner who had deducted the costs of chartering private airplanes as a business expense. At face value, the costs he deducted seemed extravagant, and they were challenged by the auditor.

"After reviewing the invoices for each of these flights and having discussions with the hotel owner," she explained, "I was able to support the fact that a team of his executives were traveling together to search for new properties to expand their portfolio of hotels, and the cost of chartering the plane was actually less expensive than paying for separate airplane tickets for all of the executives to travel. The auditor accepted this explanation, and the expense was deemed deductible."

Travel expenses. Sole proprietors and independent contractors are permitted to take a number of tax deductions for expenses associated with doing business in order to reduce their taxable income, but it has to be reasonable. You can't, for example, deduct the daily costs of commuting or claim that all of your automobile travel expenses were for work if you have one car.

For a trip that is solely for business purposes, you can deduct 100% of the reasonable and necessary expenses of getting there and back, 100% of lodging costs and incidental expenses, plus 50% of the cost of meals. The costs of having your spouse join you would not be considered necessary, similar to lavish meals at five-star restaurants on business trips away from home. And always keep receipts and any other documentation that support the business purpose for the expense, whom you ate with, etc.

Charitable donations. "Many physicians are involved in charities through hospital functions or on their own," said Martinez. "They may donate and seek to deduct money or goods and should be fine as long as your income is high enough for the amount donated to be considered reasonable." Again, be sure to keep proof from receipts or letters from the charity itself and submit it with your return. If you don't have the proof, don't claim it.

Be Precise

Taxpayers often have a "tell," to use gambling parlance. Rarely do figures (such as expenses) end in a zero, so the more zeroes you have, the more you're signaling that you don't have documentation and are guessing. If you do round off or up, round to the nearest dollar, not the nearest hundred (so $186.82 would be $187, not $200).

And be sure the data entry and calculations are correct. Whenever you're transferring data from one place to another, there's the risk of making a numerical error. This is greatly reduced by using commercial tax software, which allows you to automatically load the data from important documents as well as prior years' returns, so there's less for you to input. It's the direction in which the majority of taxpayers are clearly headed; 89.2% of returns were e-filed during the tax season for 2018.

Some final words of wisdom: "If you do receive a letter questioning your return, don't ignore it. Some are afraid and just try to bury it, which is the worst thing you can do," cautioned Martinez. "Instead, address the issue as quickly as possible." And don't go it alone — especially if you receive a notification requiring a face-to-face appearance. "It's essential to talk to a tax professional who is qualified to represent you in front of the IRS and can accompany you or even go in your place."

Marcy Tolkoff, JD, is a freelance writer based in Fort Lee, New Jersey.

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