There’s no sure way to avoid an IRS audit of your tax return, but these red flags could increase your chances of drawing unwanted attention from the IRS.
The IRS audited only 0.4% of all individual tax returns in 2019. The vast majority of exams were conducted by mail, which means that most taxpayers never met with an IRS agent in person. Plus, the IRS audit rate is expected to drop even lower for 2020 because of the coronavirus pandemic.
Failing to Report All Taxable Income
The IRS gets copies of all the 1099s and W-2s you receive, so be sure you report all required income on your return. IRS computers are pretty good at matching the numbers on the forms with the income shown on your return. A mismatch sends up a red flag and causes the IRS computers to spit out a bill. Report all income sources on your 1040 return, whether or not you receive a form such as 1099.
Taking Higher-than-Average Deductions or Credits
If the deductions or credits on your return are disproportionately large compared with your income, the IRS may want to take a second look at your return. But if you have the proper documentation for your deduction or credit, don’t be afraid to claim it.
Taking Large Charitable Deductions
If your charitable deductions are disproportionately large compared with your income, it raises a red flag.
That’s because the IRS knows what the average charitable donation is for your income level. Also, if you don’t get an appraisal for donations of valuable property, or if you fail to file IRS Form 8283 for noncash donations over $500, you become an even bigger audit target. Be sure to keep all your supporting documents, including receipts for cash and property contributions made during the year.
Running a Business at a loss for many years
In 2019, the IRS examined between 0.8% and 1.6% of returns filed by individuals who ran a business and attached Schedule C reporting. You are at a higher risk if you report substantial losses on Schedule C.
Claiming Rental Losses
The IRS actively scrutinizes large rental real estate losses. It’s pulling returns of individuals who claim losses every year.
Writing Off a Loss for a Hobby
You’re a prime audit target if you report multiple years of losses on Schedule C, run an activity that sounds like a hobby, and have lots of income from other sources.
To be eligible to deduct a loss, you must be running the activity in a business-like manner and have a reasonable expectation of making a profit. If your activity generates profit three out of every five years, the law presumes that you’re in business to make a profit, unless the IRS establishes otherwise. Be sure to keep supporting documents for all expenses.
Taking Higher-than-Average Deducting for Ministry Professional Expenses
Agents are on the lookout for personal meals or claims that don’t satisfy the strict substantiation rules. To qualify for meal deductions, you must keep detailed records that document for each expense the amount, place, people attending, ministry purpose, and nature of the discussion or meeting. Also, you must keep receipts for expenditures over $75 or for any expense for lodging while traveling away from home. Without proper documentation, your deduction is lost. The 2017 tax reform law eliminated the deduction for entertainment expenses.
Claiming 100% Ministry Use of a Vehicle
Claiming 100% ministry use of an automobile is a red flag for IRS agents. They know that it’s rare for someone to actually use a vehicle 100% of the time for their ministry, especially if no other vehicle is available for personal use.
Be sure you keep detailed mileage logs and precise calendar entries for the purpose of every trip. Poor recordkeeping makes it easy for a revenue agent to disallow your deduction.
As a reminder, if you use the IRS’s standard mileage rate, you can’t also claim actual expenses for maintenance, insurance, and the like.
Incorrectly Reporting the Health Premium Tax Credit
The premium tax credit helps individuals pay for health insurance they buy through the marketplace. It’s available for people with household incomes ranging from 100% to 400% of the federal poverty level.
The credit is estimated when you go on a marketplace website such as healthcare.gov to buy insurance (the estimated premium subsidy for 2021 will be based on your expected 2020 income). You can choose to have the credit paid in advance directly to the health insurance company in order to lower your monthly payments. You then have to attach IRS Form 8962 to your tax return to compute your actual credit, list any advance subsidy paid to the insurer, and then reconcile the two figures.
Claiming the Home Office Deduction and a Housing allowance
More people then ever worked from home for part or most of 2020 because the COVID-19 pandemic caused their employers’ offices to shut down. These people would love to write off the cost of their home offices. Unfortunately, most won’t be able to take the deduction. That’s because it’s not available to employees.
The deduction is still available to self-employed people or independent contractors who use a room or space in their home exclusively and regularly as their principal place of business. You don’t need to own a home. Renters can also get this deduction. There are two ways to figure the write-off: Allocate actual costs or use the simplified option in which you can deduct $5 per square foot of space used for business, with a maximum deduction of $1,500.
Your audit risk increases if the deduction is taken on a return that reports a Schedule C loss and/or shows income from wages.
Reporting Clergy Income on Form 1099
Most ministers serving a church are treated as dual-status taxpayers. They are employees for income tax purposes and self-employed for Social Security. Churches should issue a Form W-2, not a Form 1099, to minister employees.
A minister received a Form 1099-MISC for other self-employment income from weddings, baptisms, etc., This income should be reported on Schedule C, Form 1040.
Inconsistencies or errors on W-2 Form For Clergy Income
When a mistake happens on an employee’s Form W-2, Wage, and Tax Statement, it’s important to correct it immediately and avoid any potential fines. We are listed a few common reporting errors below.
- Withholding FICA taxes on clergy income
- Not reporting employee 403(b) contributions – Box 12
- Not reporting dependent care benefits – Box 10
- Not reporting employee paid HSA contributions – Box 12
- Reporting housing in box 1 – Housing should be excluded from box 1 and reported in box 14
- Not reporting housing – Box 14
Not Reporting Honoraria Income
Like other forms of income, an honorarium is taxable and must be reported on your tax return. Organizations paying honoraria report them to both the minister and the Internal Revenue Service (IRS) on a 1099-MISC form if compensation is $600 or greater in one calendar year. An honorarium is also subject to self-employment tax.
Clergy Financial Resources serves as a resource for clients to help analyze the complexity of clergy tax law, church payroll & HR issues. Our professionals are committed to helping clients stay informed about tax news, developments and trends in various specialty areas.
This article is intended to provide readers with guidance in tax matters. The article does not constitute, and should not be treated as professional advice regarding the use of any particular tax technique. Every effort has been made to assure the accuracy of the information. Clergy Financial Resources and the author do not assume responsibility for any individual’s reliance upon the information provided in the article. Readers should independently verify all information before applying it to a particular fact situation, and should independently determine the impact of any particular tax planning technique. If you are seeking legal advice, you are encouraged to consult an attorney.
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