It is that time of the year when people determine whether they will receive a tax refund or owe a tax liability, and Taxpayers should be aware that the IRS is likely to step up their audit game this year due to the pandemic-inspired federal grant, loan, and tax-credit programs. These programs have increased the complexity of filing for individuals and business owners, and highlight the need to seek tax advice from tax professionals to help ensure returns are filed correctly and minimize chances of being audited. Below are a few red flags the IRS is looking for when determining which returns to audit:
Education Tax Credits. There were two types of education credits available: (1) the American Opportunity Tax Credit, a partially refundable credit of up to $2,500 for students pursuing an undergraduate degree, and (2) the Lifetime Learning Credit, a non-refundable credit of up to $2,000 for individuals pursuing a career change or advanced education training at a postsecondary school. Both credits have certain eligibility requirements that must be met to qualify, and claiming the wrong credit or claiming both in the same tax year will likely cause the IRS to flag and audit the return.
Small Businesses. The IRS is likely to scrutinize cash intensive businesses as they sometimes report excessive deductions while underreporting income. Business owners who received forgivable emergency stimulus loans under the Paycheck Protection Plan created by the CARES Act should be prepared to certify that the proceeds were used to cover qualified payroll costs, utilities, rent, and mortgage interest, otherwise nontaxable forgiveness may not be available. Other items the IRS will be looking out for is whether business funds were intermingled with personal funds, whether excessive losses were reported in relation to earlier years, and whether excessive travel and entertainment expenses were reported.
Cryptocurrency Transactions. On the front page of the 1040 is a question asking whether the taxpayer received, sold, traded, or disposed of any financial interest in a virtual currency during 2021. This means that someone who received any cryptocurrency, including likely nonfungible tokens, must check the box even if they did not have any taxable dispositions. The IRS has a mandate to collect $30 billion in cryptocurrency tax revenue over the next ten years, and treats all digital currency as capital assets for tax purposes, subject to short and long term capital gain tax. The IRS is cracking down on the underreporting of cryptocurrency income, including cryptocurrency transactions where the cryptocurrency was either traded for a separate cryptocurrency or spent on a product or service, both of which some taxpayers may not realize is treated as a taxable disposition by the IRS.
Rental Income. Many people have joined the rental business, thanks to sites like VRBO and Airbnb, yet they are unaware that rental income is passive income. This means if a rental loss is sustained, and there is no other passive income (e.g., only W-2 income is earned), then the taxpayer may not be able to deduct the loss against the other income, depending on a complex set of rules involving income level phase outs and the amount of active participation in the rental activity. Additional rules apply if the property is used as both as personal residence or vacation home and as a rental. The IRS is looking to see whether rental income is underreported, and whether excessive or vague deductions were claimed.
Early Withdrawals from IRAs and 401(k)s. Generally, payouts from a traditional IRA or 401(k) before the age of 59½ incurs a 10% penalty on top of regular income tax. The Covid-Related Tax Relief Act of 2020 waived the 10% penalty to provide relief to certain taxpayers impacted by the pandemic, but the penalty was reinstated last year. It’s important that all taxable income stated on Form 1099-R is reported and documented as the IRS will automatically cross-check the return with the information provided to them by retirement companies. Further, if a covid-related distribution was made from an eligible retirement plan to a qualified individual, then the distributions may be included in income ratably over a three-year period. Therefore, the second distribution could need to be reported on this year’s tax return.
Charitable Contributions. If the total charitable deductions reported are high compared to annual income, the IRS is more likely to review and audit the return. The IRS looks at whether the taxpayer has a lack of receipts, canceled checks, and written acknowledgements for any donation of $250 or more; they also look at whether the values for noncash donations were inflated or whether any required appraisals were obtained; finally, they look at whether qualified charitable contributions from an IRA are properly documented.
It is important is to limit audit risk by filing a complete and accurate return. When handling any complex tax matter, reach out to a tax professional for assistance, as it’s typically cheaper and easier to get assistance with preparation than once an audit has been started.