No taxpayer wants to receive a notice that their tax return is being audited, though audits are a fairly common occurrence. There are a number of things that might trigger a tax audit; one common audit trigger is your investments. But what happens when you get audited? Here is some information on tax audits that all investors (and taxpayers) should be aware of.
What Is a Tax Audit?
A tax audit is an in-depth review of your taxes for one or more tax years initiated by the IRS. Audits can also happen at the state level as well.
An audit means that your return or returns triggered some sort of red flag by the IRS computers as they reviewed your return. Overall, your chances of being audited by the IRS are extremely low. According to CNBC, only 0.45% of individual returns were audited in fiscal year 2019, down from 0.58% in fiscal year 2018 and 1.11% in fiscal year 2010.
What Will Trigger a Tax Audit?
Many things can trigger a tax audit. The IRS may be on the lookout for a particular trait or issue, and your return triggers that audit red flag in their system. These issues may change over time based on what the IRS is seeing or other issues. The IRS' computers work via algorithms, which are programmed for each tax season.
A few potential situations that could trigger an audit include:
- If a business partner or a fellow investor in a business that you are involved in gets audited, the IRS may look to their associates as audit candidates.
- Reporting no income, especially doing so over a number of years, can trigger an audit.
- Those in a high-income bracket are more likely to trigger an audit. The threshold can change, but those with incomes of $10 million or above may be more at risk of an audit.
- Certain types of investments can trigger an audit.
- Filing an estate tax return for a large estate can trigger an audit.
- Late filers also run a risk of being audited.
How Your Investments Might Trigger an Audit
Investing is an activity that has a lot of potential to trigger a tax audit. Here are some aspects of investing that can trigger an audit:
Dividends and Interest
If you receive dividend and interest payments from one or more investments, these payments are reported to the IRS via a 1099 form (which you also receive). These payments might be dividends from a stock you own or perhaps distributions from a mutual fund or exchange-traded fund (ETF).
If your return has omitted dividend and interest payments received, this might cause the IRS to flag your return due to the missing income that was reported to them.
If you sold securities during the year — such as shares of an individual stock, a mutual fund, an ETF or others — your brokerage firm will include the sale proceeds on the year-end tax statement you receive from them. It won’t list whether or not you sold the securities for a gain or a loss, but the IRS will see the amount you received from this sale and expect to see this amount included in your tax return as either a capital gain or a capital loss. This could trigger a tax audit if it's not included in your return.
Some companies may offer groups of employees stock-based compensation in the form of options, restricted stock units (RSUs), or other forms. There are various points at which these different types of stock-based compensation can generate taxable income. In some cases it's when the grant occurs; in other cases it might be when you sell the associated shares. Your employer will generate a notification of this income to you with a copy to the IRS.
An audit can also arise if you sell your shares through a broker. If you fail to report this income in either case, or if you do it incorrectly, you may trigger an audit situation.
Real Estate Investments
Investing in real estate can allow for a number of legitimate deductions. However, some of these deductions can be subjective. If you get too aggressive in this area you could trigger a tax audit.
Things like excessive mortgage deductions and unsubstantiated repair costs can be a red flag for the IRS.
What If You Are Audited and Don’t Have Documentation?
If you have receipts or other documentation for the transactions or other issues under audit, this is the best situation.
If you don’t have proper documentation, you may still be able to salvage all or some of the deductions in question. Below are a few ways you can develop supportive documentation:
- Review bank and credit card statements to find transactions such as business expenses, that may be deductible. You can then potentially go back and obtain receipts in some cases.
- Review your calendar to note mileage and related business expenses in connection with client meetings or attending a business event.
- If you've made a charitable contribution, you should be able to get a copy of the donation receipt from the organization.
This is an area that you likely don’t want to tackle yourself. Working with a tax professional can help navigate the audit overall, and specifically with your efforts to reconstruct records of deductions that may be in question.
How to Avoid Tax Audits
While there is no 100% surefire way to avoid a tax audit, there are some things you can do to reduce your chances of being audited:
- File a return each year: Even if you think you don’t have any income, or don’t owe any taxes, it’s still wise to file a return. If the IRS sees you have filed in the past and didn’t file for the current tax year, this could trigger an audit.
- Use a reputable tax preparer: You might be tempted to use a tax preparer who claims that can reduce your taxes or get a larger refund for you than anyone else. Make sure this person is reputable and not under investigation by the IRS themselves. There are some tax preparers on the IRS’ “list” and those who use them might be more susceptible to an audit.
- Be honest: If you try to hide income or file a false return, you’ll likely get caught. You may also find yourself to be a target of the IRS on a recurring basis.
- File within the required deadlines: Note when your filing date is and be sure to have your documents ready.
- Don’t push: Don't use questionable deductions.
How to Deal With an Audit
If you are audited you should hire a tax professional who is experienced in dealing with the IRS on audits. A few tips:
- The IRS will only contact you via a letter in the mail. If you receive a phone call purporting to be from the IRS it is likely a scam. Don’t fall for it.
- Gather all documentation for all income and expenses for the tax return in question.
- Respond to all inquiries and requests in a timely fashion. If you mail them information, be sure to request a confirmation of delivery when sending via the USPS.
If you use a tax preparer or a tax service, see what types of audit support are available. But if you are not comfortable with what is offered, hire someone experienced in dealing with an IRS audit.
Being audited by the IRS is a scary feeling, and an audit can be triggered for any number of reasons. That said, the percentage of audited tax returns is very small.
If you find yourself audited, don’t panic. Gather all documentation pertaining to the tax return in question and consider hiring a tax professional who is experienced in dealing with audits to represent you.