IRS Audits: High Net Worth Individuals and Small Businesses Have Highest Audit Risk
High Net Worth Individuals and Small Businesses Have a Greater Risk of Being Audited by the IRS
Learn why the IRS tends to audit high net worth individuals and small businesses, and what you can do to avoid an audit in the future
For most of us, April 15 is not a day we look forward to. This date signifies the deadline to file taxes, and while it is only one of 365 days in a calendar year, the anxiety, work and ordeals we must undergo to ensure we file our taxes on time – and correctly – can be all-consuming.
After the deadline, we tend to breathe a sigh of relief knowing the arduous process is finally over. Unfortunately, for some, what lies ahead is a slew of IRS investigations and potentially exorbitant financial (or even criminal) penalties. This is the unfortunate reality for taxpayers who become the target of an IRS audit – a reality that is even more likely for high net worth individuals and small business owners.
What Is an IRS Tax Audit?
Before we address why high net worth individuals and small business owners are more prone to being audited by the IRS, let’s first address what an audit actually is and what it entails.
According to the IRS, a tax audit is “a review/examination of an organization's or individual's accounts and financial information to ensure information is reported correctly according to the tax laws and to verify the reported amount of tax is correct.”
Basically, this means something on your tax paperwork appeared a bit suspicious or out of the norm to the IRS, so your tax return was flagged and investigated. Or, it could simply mean that you were one of the very unlucky taxpayers to be randomly selected for a review – yes, the IRS can (and often does) audit individuals and businesses at random.
What Happens If You Get Audited by the IRS?
If your tax return is audited, you will find out in about a year’s time or less after the tax deadline for a particular year – though it can take three years (or more). The IRS will send you a written notice by mail, which outlines the details of the audit’s findings, items you may have failed to report but were discovered, inconsistencies and what you essentially “owe” to the U.S. Government. The audit notice may also request that you provide additional information regarding the findings. For more general/minor instances, a simple mail response will usually suffice. However, for larger discrepancies, the IRS may request to meet with you in person.
Why the IRS Tends to Target High Net Worth Individuals and Small Businesses for Tax Audits
High Net Worth Individuals
It’s no secret that the wealthy tend to have their income earnings and assets scrutinized more heavily by the IRS, particularly high net worth individuals (those whose assets total at least $1 million). In fact, according to statistics, high net worth individuals are five times more likely to be audited than taxpayers in lower income brackets. Why? The higher your income, 1) the higher the chance that you may fail to declare the full amount of your earnings – whether by accident or purposefully to avoid paying Uncle Sam and 2) the higher the amount the IRS may potentially collect from you if an audit determines that you owe money in taxes.
Also, given the fact that many high net worth individuals hold their assets in offshore banks – along with the fact that the IRS is upping its efforts to investigate foreign accounts – the agency may dig deeper into any funds you may be holding overseas. Reporting offshore accounts and assets isn’t the easiest of undertakings. Though many foreign account holders make an earnest attempt to disclose the values of their accounts when filing U.S. taxes, the requirements are stringent and many taxpayers inadvertently omit key information or unwittingly fail to declare the full extent of their earnings or investments.
Like high net worth individuals, the IRS tends to target small businesses for audits because of the notion that such businesses may be underreporting business income in an attempt to avoid paying taxes. The more your business makes, the greater your chances of being audited. In recent years, the IRS has been taking a closer look at the number of small business cash versus credit card transactions, focusing on those that have a higher volume of credit card transactions. However, the idea that a higher number of card (credit or debit) transactions and lower number of cash transactions can somehow correlate to underreporting profits can be a flawed assumption.
We live in a digital world where many purchases are made via the Internet with credit/debit cards. Online versus in-person sales are booming, and are projected to continually increase. Plus, some consumers prefer to pay for merchandise or services with their credit or debit cards, as they can keep a better record of their transactions, enjoy greater protections against theft or fraudulent purchases, and can potentially earn benefits if they are enrolled in a card rewards program. Many consumers also use Mobile Pay for purchases, seeing as how nowadays, it’s a lot more likely to forget your wallet at home than to leave your cell phone behind.
Given these factors, it’s only natural to expect a substantial number of small businesses to report higher-than-average card-related sales. Still, if the number of credit card transactions reported by a company far exceeds cash transactions, their business return may be audited.
Small business owners also have a high audit risk because of claimed business expenses. Home offices, vehicles, business luncheons or dinners, entertainment expenses and travel costs must be reported as accurately as possible. Too many of these types of deductions, along with too many reported losses (especially if the business claims losses year after year) in general, can lead a small business to fall under the IRS’s radar and be selected for a company audit.
Top 7 Factors That Can Trigger an IRS Audit
If you are a high net worth individual or a small business owner, you are already more likely than most Americans to be audited by the IRS. That being said, several elements play a role in determining whether or not a tax return may be chosen for audit. Below are the top 7 IRS audit triggers and how they affect larger income earners and small business owners.
- Income Extremes – Those who make $1 million in income a year or more and those who report little to no income are likely candidates for an IRS tax audit. The IRS often operates under the assumption that individuals and businesses that make the most money may also have the most incentive to either underreport their actual earnings or report uncharacteristic and excessive losses to avoid higher taxes. If a tax return shows too little income, the IRS may be prompted to initiate an audit to determine whether the taxpayer truly earned what they claimed.
- Higher-Than-Average Number of Deductions – When determining audit selection, the IRS uses a computer program to compare income declarations and deductions for individuals and businesses within specific income brackets. Those with a higher-than-average number of deductions for their income bracket are more prone to being audited.
- Deductions That Exceed Reported Earned Income – Aside from the total number of deductions on your tax return, the actual amount you are claiming in losses plays a significant role in determining your likelihood of being audited. When your deductions exceed your reported earned income (meaning you are reporting a loss of income versus a gain for the year), there’s a good chance the IRS will take notice and will want to know why. If you have supporting documents that validate your net losses, then you can breathe a (slight) sigh of relief. This is one of the many reasons why keeping a good record of all your financial transactions is key when preventing and/or overcoming an IRS audit. Also, if you have just incorporated a business and this is your first time filing taxes for said company, it’s natural (and often expected) that you may suffer losses in the beginning. It can take a considerable amount of time for start-up ventures to realize profits, since the first few years are dedicated to paying for real estate space, equipment, new hires, marketing campaigns and loans. However, if you’ve run a successful business for several years and – without a viable reason – suddenly begin declaring huge losses without proof to back up your claims, not only are you highly likely to be selected for a tax audit, you may also be liable to pay expensive fines and may even be hit with tax evasion charges.
- Claiming Miscellaneous Deductions or Superfluous Expenses – Out-of-the-ordinary expenses that are not commonly claimed as deductions by other taxpayers can raise IRS agent eyebrows. Home office, travel, meal and entertainment expenses are among the most heavily scrutinized deductions – and those that high net worth individuals and small businesses tend to claim the most. Too many of these types of deductions, or for business owners, intermixing personal expenses with business expenses, can trigger an audit.
- Conflicting Information – Inconsistencies between your return and those of any taxpayers that you were involved in transactions with (including sales, purchases, payable services, business partners or investors) can easily trigger an IRS tax audit. This is especially true if your tax return happens to account for lower sales or purchases than were actually rendered, lower transaction values or a higher number of deductions.
- Offshore Accounts – As previously noted, the IRS is cracking down on foreign account reporting. Anyone who earns income outside the United States, is the primary account holder or has signature authority over a foreign bank account, or conducts business overseas is much more likely to be audited than a U.S. taxpayer whose earnings and investments are made/held domestically.
- Random Selection – Although the IRS compares tax returns filed by individuals and small businesses in the same income bracket, many times, taxpayers are selected at random for audits. This doesn’t mean you did anything wrong in your paperwork, it just means you happened to be selected by a computer through “luck of the draw”. Additionally, if a business is selected for audit, the IRS will more than likely audit all employees – current and former.
What to Do If You Are Audited?
First, keep calm; you are not the first person to have your tax return audited by the IRS. Second, it’s important to remember that an audit is not a final verdict. You have the option to file an appeal and dispute the audit report by providing supporting documents that back up your claims. Hence, why it is vital to keep copies of all your sale and purchase receipts, pay stubs, bank and investment account stubs and other important documents that will substantiate your claim in the event your tax return is selected for audit.
Sometimes, you may have to just bite the bullet and pay the amount the IRS is asking for if you have no proof to refute the audit’s findings. However, if you are being told that you owe a substantial amount of money to the U.S. Government in both back taxes and interest, or are being accused of tax fraud or evasion, you may benefit from speaking with an experienced IRS lawyer who can advise you of your rights and file a claim on your behalf.
7 Steps to Prevent Future IRS Audits
Whether you have been audited already or want to lower your chances of having your tax return flagged in the future, there are numerous steps you can take to avoid getting on the agency’s radar as a high-income earner or small business owner. Follow these seven key steps and you can reduce your audit likelihood:
- Keep Excellent Records – The best way to avoid being audited is to stay organized and maintain a thorough record of all your individual and business expenses. Keep all purchase and transaction receipts, including those related to sales, equipment and office-related purchases, bank deposits and withdrawals, business gains and losses, stock transactions, payroll, tax deductions (including business trips, mileage, transportation, parking costs and hotel expenses) and other business-related expenses. The IRS can audit you for up to six years after filing a tax return. Usually, the agency tends to stick to returns filed within the last three years but if substantial errors are discovered, the IRS may audit previous returns as well, which can cause a delay in taxpayer notification. Given the auditing timetable, it is wise to keep your tax paperwork and prior return records for at least seven years – 10 if you really want to be diligent and protect yourself against a possible audit. We recommend keeping both paper and electronic copies of all tax-related documents so you’ll always have a backup.
- Avoid Omissions – Accounting for every single source of income, from small sales to stock earnings, can help you avoid an audit – even if your profit was a mere $100. If the IRS discovers that you failed to claim something on your tax return – no matter how inconsequential the figure – this may trigger an audit and also a review of previous returns for accuracy. Not only can you be liable to pay back taxes, you’ll also be responsible for paying interest accrued starting from the tax filing deadline.
- Be as Detailed as Possible – If you are claiming deductions, avoid claiming them as “miscellaneous expenses”. Be as detailed as possible when explaining an item you are claiming for deduction. For example, instead of lumping your business purchase into one item listed as $10,000 in miscellaneous office expenses, note each item carefully and the amount it cost (i.e. $5,000 spent on 10 new office computers; $3,000 spent on new security cameras; $1,000 spent on office supplies including stationary, pens, printer paper, printer ink; $1,000 spent on cleaning services). Additionally, refrain from leaving any items blank.
- Include Supporting Documents With Your Tax Return – While taxpayers who claim higher-than-average deductions on their tax returns have a greater chance of being audited, this doesn’t mean you should shy away from claiming your expenses. However, it’s important to provide supporting documents for all your deductions. All those records you kept, put them to good use. Include copies of receipts, payments, bank and credit card statements, bills and other materials that will validate your deductions. The IRS is especially nitpicky about home office, travel, meal and entertainment expenses, so be sure to provide documents that back up these types of deductions.
- Double-Check Your Numbers – Before you submit your tax return, be sure to double (and even triple check) your figures. If you miss just one small item or make a mistake in your calculations, an audit can be triggered. If possible, consider having your work checked by a tax professional or accountant.
- Get a Head Start on Your Paperwork – Tax paperwork can be extremely complex, requiring a meticulous review of your previous year’s documents, gains and expenditures. Gathering, analyzing and inputting data on your tax return takes a considerable amount of time. If you procrastinate, you risk making a critical mistake when hastily attempting to compile your information on the cusp of the deadline. Getting an early start on your taxes affords you sufficient to accurately review your purchases, sales, gains and losses, as well as collect pertinent receipts and proof of transaction history.
- Consult With an Experienced Tax Attorney – Tax attorneys focus their practice on all things pertaining to IRS matters and know exactly what areas on a tax return can raise a red flag. Your attorney will review your paperwork, earnings and losses prior to filing your return and pinpoint any areas that should be revised or for which you may need to provide further documentation. A tax lawyer can also advise you if you have already been audited and guide you through the appeal process so the most favorable outcome can be attained.
Are you a high net worth individual or small business owner worried about your chances of being audited? Have you already been audited and need assistance contesting the IRS’ findings? Thorn Law Group can provide you with the tax audit help you need. As a former attorney for the IRS, Kevin E. Thorn understands the auditing process thoroughly and will help you minimize your losses. Contact Managing Partner Kevin E. Thorn today to schedule a confidential consultation.