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California artist Joan Brown’s cat, Donald, is her muse and model. Brown, who’s painted dozens of portraits of Donald, considers him to be a business asset and lists cat food and vet bills among the deductions on her tax return.
The Internal Revenue Service initially said no, but Brown successfully argued that the deductions should be allowed, according to a Feb. 20 report on NPR’s All Things Considered, earning the cat the nickname “Donald the Deductible.”
“That’s definitely on the fringe,” says Nate Tassler, owner of That Tax Guy, tax instructor at Pikes Peak State College and director of the college’s VITA tax preparation program.
“Every case like that ultimately comes down to facts and circumstances,” Tassler says. “What’s your story, and what can you prove?”
It’s also an example of the kind of deduction that draws the attention of the IRS.
But the No. 1 item most likely to result in an IRS audit is incorrect reporting of income on your tax return, tax experts say.
Forms 1099 and other governmental forms in the IRS system that don’t match up with a return will cause it to be red-flagged, says Buddy Newton, tax partner at Stockman Kast Ryan + Co, and adjunct professor at UCCS.
“That will generally create some type of correspondence audit, via a letter from the IRS with an adjustment proposed,” he says. “That takes time and money to respond to or to look at, and if you didn’t report the income, they’re going to assess whatever tax is due. If it hasn’t been paid timely, there will be interest and penalties imposed as well.”
The first thing to do if you are subject to an audit is to find an enrolled agent — someone credentialed by the IRS to represent taxpayers, a CPA or a tax attorney, says Susan Puckett, owner of Stark Tax Services.
The IRS conducts some random audits, Puckett says, and audits have increased over the past five years.
“If you’re a higher-income taxpayer, your chances of going through a full audit or a correspondence audit randomly generated by their system is greater,” Newton says. “There’s likely more items inside of that return that could be reported wrong.”
Here’s what Tassler, Newton and Puckett advise taxpayers to do to lessen the chances of an audit and to make sure you have the best outcome if you are audited.
Keep track of all W-2s and Forms 1089 and 1099 and make sure that income is listed on your return. Sometimes people will inadvertently omit money they took out of a retirement account, Tassler says. That can happen if you leave a job, withdraw money from a 401(k) plan and forget to report it, he says.
Don’t incorrectly claim a dependent. “Something we see quite often is folks may claim a child on their return when someone else has already claimed that child,” Newton says. That can occur when parents are getting divorced or when a divorce decree allows parents to claim the child in alternate years. “Sometimes a parent will claim a child when it’s not their year,” he says.
If you’re self-employed or have gig income in addition to W-2 income, make sure you understand the rules for deducting expenses such as meals and mileage. “The IRS loves to audit things like mileage,” Tassler says. “If you can’t prove the deduction, you can’t take it.” Gig income is reported on Schedule C. “You do have to pay income tax on whatever your net earnings are after expenses,” he says. If you have net earnings of $400 or more, you also pay self-employment tax on those earnings.
If you’re claiming a home office deduction, make sure you’re following the rules. First and foremost, you cannot take a home office deduction if you are an employee, even if you work remotely full time. If you are self-employed, you can claim the deduction for a space that you use regularly and exclusively for business and you don’t do anything else there. “A kitchen table cannot be a home office, because you also eat dinner there,” Tassler says. The home office deduction can reduce your profits but can’t create a loss, he says. “If you already have a loss from your business, based on your other income and expenses, the home office doesn’t help you.” It can, however, draw the attention of the IRS.
Large charitable deductions, especially non-cash deductions, may red-flag your return. If you want to deduct a donated vehicle or work of art valued at more than $5,000, “you’re required to have an appraisal of that value,” Newton says.
Don’t violate the “hobby loss rule.” This can happen when a sole proprietor reports losses for more than three years. “That will generally create a red flag for the IRS that this is potentially a hobby,” Newton says. “Certainly a business in startup mode can incur losses,” he says, “but what tends to happen is that people try to run their hobbies through a Schedule C and take that loss to offset income. The IRS looks at that pretty heavily.” Business owners who know they’re likely to have losses for several years can avoid the red flag by setting up an S corporation. “Losses aren’t as heavily scrutinized when it’s a separate business filing,” Newton says. But big losses also may flag a return, Puckett says.
Properly report gambling winnings. Gaming facilities are required to report winnings on a W-2G tax form when they exceed certain amounts depending on the type of gambling — for example, slot machine winnings of $1,200 or more. “The casino is required to send you that tax document,” Newton says. Net losses are not deductible, but net winnings must be reported.
If you’re audited
If you’ve filed correctly, you’re unlikely to hear from the IRS, unless you’re among the unfortunate 1 percent of taxpayers who get picked by a computer for a random audit.
“They’re randomly picking people to verify their Social Security number and verify who they are,” Puckett says. That’s being done because fraudulent use of Social Security numbers is on the rise.
Congress has allocated money to the IRS to hire more agents, but Puckett does not anticipate that will greatly increase the number of audits.
“They are so short of agents that it’s insane,” she says. “Since April 2020, it’s taken a good two or three days to get hold of someone at the IRS.”
Taxpayers whose reported income doesn’t match IRS records usually will receive a letter called a CP2000 notice that proposes an adjustment to the return. If you agree with the proposed changes, the IRS states on its website, you return the response form and pay the proposed amount, if any, within 30 days. If you disagree, you’ll need to submit a signed statement explaining why and provide supporting documentation.
Send everything by certified mail, Tassler recommends. The IRS considers documents filed on the date you send it if you use certified mail.
If you can’t prove the deduction, you can’t take it.
— Nate Tassler
The worst thing you can do is to ignore the correspondence, which can result in additional interest and penalties. You can ask for an extension if you can’t respond within the time frame, Tassler says.
The IRS initiates most contacts by mail, but in rare cases, an IRS agent will show up at your house or place of business, Puckett says. According to the IRS website, that can occur when you have an overdue tax bill or a delinquent return, or if an agent needs to view assets or tour a business as part of an investigation or audit.
If an agent approaches you in person, verify their identity — all agents carry a badge and ID, and contact an enrolled agent, CPA or tax attorney and let them represent you, she says.
If the IRS requires you to come in for an audit, you’ll be told specifically what portion of your return is being audited and what to bring.
Well-organized taxpayers are ahead of the game, Tassler says. When you respond, stick to facts and provide only necessary documentation.
“The people that process correspondence audits generally have a heavy workload. If your information is not clear, they may not find in your favor, even if the evidence supports you,” he says.
Using accounting software like QuickBooks or Xero is a huge advantage when the IRS asks for records, Tassler says. For example, the IRS has specific requirements for deducting business meals, including keeping records of who was there and what was discussed.
“If you’ve scanned your receipts and entered the information, you can print out a report, and you’re way ahead of the game,” he says.