The Inflation Reduction Act will have a big impact on tax law. One specific portion that has led to concern is how the Internal Revenue Service (IRS) will use the $80 billion in funds it will receive over the next decade as a result of the passage of this law. Although analysts and tax groups state the funds will likely focus, at least initially, on hiring staff to help address the millions of backlogged tax returns, skeptics continue to voice concern that the IRS will use the funds to come after taxpayers with an increase in tax audits.
Statistically, the risk of an audit remains low. A recent analysis by Kiplinger points out that the IRS audits less than 1% of individual tax returns every year. But how do the feds choose their targets? Although we do not know exactly how the feds choose who to and who not to audit, we know that there are some red flags that can increase your risk. These triggers break down into four main categories.
#1: High earnings
The more you make, the more likely you are a target of an audit. The treasure department supported this when they announced those who earn less than $400,000 will not experience an increase in audit rates. The IRS is clear in its focus on high earners and even has a dedicated group, the high-wealth exam squad, that specializes in the tactics high earners commonly use to reduce their tax obligations.
That does not mean these tax saving actions are illegal, just that they may come under increased scrutiny. It is a good idea for those who use these practices to review their strategy and make sure the tactics in use comply with applicable tax law.
#2: Unreported income
It may be tempting to avoid falling into the category of a high earner by not reporting income, but it is important to know that if you make money, the IRS likely knows about it. Lottery winnings, side-gigs, and other ways we may experience an increase in funds do not go unnoticed. These earnings are often reported by the source directly to the IRS. If you get a 1099 or a W-2, so does Uncle Sam. As a result, any discrepancies in what you report as income and what the IRS has on file is likely to increase the risk of an audit.
As a related sidenote, the IRS will also notice if you choose not to file tax returns. A failure to file will trigger scrutiny.
#3: Business ownership
Entrepreneurship comes with many benefits, including tax savings. The rules are complex, and it is easy to make a mistake. As such, the IRS is more likely to closely review those who own their own businesses to make sure they do not run afoul of tax laws.
#4: Tax deductions and credits
The IRS will notice if your tax deductions and credits are not in line with your income. Credits and deductions that will often warrant a closer look include losses due to rental and hobbies. The IRS may also review filings more closely if you claim the American Opportunity Tax Credit, health premium tax credit, or research and development credit.
Important takeaway: Keep records
These red flags do not mean that you should avoid making use of these credits, deductions, and tax planning strategies. They just serve as a warning to do so wisely. Have paperwork to back up your actions and be prepared to fight back in the event of a tax audit.