What are 8 common reasons for getting audited by the IRS?

[00:00:00] Ralph Estep, Jr.: Have you ever wondered what might trigger an IRS audit? Imagine, if you were opening your mailbox to find that dreaded letter from the IRS. Your heart races, your palms sweat, and suddenly, your whole financial world feels like it's about to crumble. But what if I told you there are ways to significantly reduce your chances of ever receiving that letter or even getting audited in the first place? Well today, I'm going to explore not just how to avoid an audit, but also what to do if you find yourself face to face with an IRS agent. Today, we're diving into the 8 most common reasons the IRS might put your tax return under the microscope. Stay tuned to learn how to avoid these red flags and protect yourself from the stress of an audit. And I'll tell you, I've been through them with clients, and they do get stressful.

[00:00:55] Ralph Estep, Jr.: Before we jump into today's episode, let's take a quick look back at yesterday's show. Yesterday, we talked about how to set up your infant, yes, you heard me right, on the path of great credit. It was a great show. If you missed it, you could check it out at askralph.com. And the takeaway from yesterday is it's never too early to start building a strong foundation for your child's future. And that starts with a strong financial foundation.

[00:01:21] Ralph Estep, Jr.: Well, let's start today's show with a message from Amy. Amy writes this.

[00:01:25] " Dear Ralph, I've been self-employed for the past three years and I am terrified of being audited by the IRS. I've heard horror stories about small business owners facing hefty fines and even jail time. It seems like I'm hearing stories every day about these 80,000 new IRS agents and how they're coming after us small business owners. Can you please send some light on what might trigger an audit and how I can protect myself? I'm trying to run my business honestly, but I'm worried I might make an innocent mistake that could cost me everything."

[00:01:58] Ralph Estep, Jr.: Well Amy, let me start by thanking you for your question. That is a concern that many of my small business clients share, and I am super happy that you reached out. Today, I'm going to address your concerns, and I'm going to give you some practical strategies to keep your tax return above board and avoid that IRS audit. And before we get started, remember, the whole point of Ask Ralph is to answer your question. So I want you to keep them coming.

[00:02:22] Ralph Estep, Jr.: Just like Amy's question today. You can send your questions to ralph@askralph.com or if you'd rather you can go right to our website. That's askralph.com. There's a microphone icon at the bottom. You could click on that and just record, tell me what's on your mind and I'll put your answer on the show.

[00:02:41] Ralph Estep, Jr.: Well, I'm thrilled you joined me today. Your trust in the show means the world to me and truthfully, I am committed to providing you with the best knowledge and insights you need to master your finances while growing in your faith. If you're finding value in the show, I'm going to encourage you to visit our website. I mentioned that a moment ago. That's at askralph.com.

[00:03:00] Ralph Estep, Jr.: I would really appreciate you joining our community and sharing the show with others who could benefit from it. If you know somebody that's going through an audit or dealing with IRS issues, this is a great thing to do. And remember, when you join our email list, you'll receive a free copy of my book.

[00:03:13] Ralph Estep, Jr.: This is it right here. Mastering your finances. Now, if you went out to Amazon to buy that, it would cost you 10 bucks, but it's my gift to you for being a part of our community. So why don't you join today?

[00:03:26] Ralph Estep, Jr.: Let's start by reflecting on a powerful verse from the Bible. This one comes from the book of Proverbs 11:1, and it says this. "The Lord detests dishonest scales, but accurate weights find favor with him." Well, that's a really good verse for what we're going to talk about today. It reminds us of the importance of honesty and the importance of accuracy in all of our dealings, especially when it comes to our finances and taxes. It's not just about following the law. But it's also about living with integrity in a way that pleases God.

[00:03:58] Ralph Estep, Jr.: Well now without further ado, let's address the burning question. Ralph, what are the 8 common reasons for getting audited by the IRS?

[00:04:06] Ralph Estep, Jr.: And I'm going to tell you to buckle up because I'm about to take you on a journey through each of these reasons. I'm going to come tell you some real-life stories that will help you understand the risks and more importantly, how to avoid them. Well, let's start with number 1. And that's a big one. That's unreported income. Just picture this. It's a warm summer evening. A friend, Tom, is sitting on his porch, he's sipping lemonade, he's feeling pretty good about life. He just finished doing his taxes. He's confident that he's done everything accurately. But little did he know a storm was brewing. You might ask why? Well, here's why. Tom had done some freelance work that year. Earning a few thousand dollars on the side.

[00:04:42] Ralph Estep, Jr.: What we call those side hustles. But when he was doing his taxes, he thought, Ralph it's just too small to report and he left it off his tax return. It turns out that was a big mistake. A few months later, Tom received that dreaded letter from the IRS. What the IRS had done is they had matched his return against those 1099 forms that his clients had sent to them. And guess what? The numbers didn't add up. What he had put on his tax return didn't match what was reported under his social security number. So guess what? Tom was facing an audit. Not only was he facing an audit, he was facing potential fines and penalties and back taxes. And bigger than that, a whole lot of stress. So what's the lesson here? Number 1, you've got to do this. Report all your income, no matter how small that is. The truth is the IRS has sophisticated systems to cross-reference your income.

[00:05:33] Ralph Estep, Jr.: Like we talked about. They're going to look at what you report on your tax return and they're going to look at what was reported under your social security number. That information could come from employers, it could come from banks, all kinds of other sources, any freelance work he did. And the truth is, the thing you need to understand.

[00:05:49] Ralph Estep, Jr.: Even a small discrepancy is going to raise that IRS red flag. Well, let's move on to the second one. And that's home office deductions. I did a show about a week ago on this. I'll put a link to that show in the show notes if you missed it. But let me tell you about my client, Maria. She's a graphic designer who worked from home and she was thrilled when she learned about this home office deduction.

[00:06:09] Ralph Estep, Jr.: She did the right thing. She measured her entire living room where she occasionally worked. Now, I'm going to remember that occasionally worked and claimed it as a home office deduction. Well fast forward a year, actually the following summer. And if you understand how audits work, it's usually about a year later, Maria is celebrating a big win.

[00:06:26] Ralph Estep, Jr.: She had just gotten a new client, a doorbell rings, and all of a sudden to her shock, guess what's standing at her front door. It's an IRS agent. Well, what triggered this? Well, there was an unusually large home office deduction that triggered an audit. So I wouldn't have advised her to do this, but she asked the IRS agent to come right in and walk through her home. And a few minutes, Maria realized that was a mistake. Because in truth, her office was also where she watched TV. She entertained guests there and even slept on the couch sometimes.

[00:06:56] Ralph Estep, Jr.: And the IRS agent explained to her that a home office must be, and I used this word earlier, intentionally. It must be used exclusively for business to qualify for deduction. But what happened to Maria? Well, Maria ended up owing back taxes. She owed penalties and they even charged her interest.

[00:07:12] Ralph Estep, Jr.: So Maria learned in a very hard way when it comes to home office deductions, you've got to be honest and accurate. And as an aside, never let the IRS in your house go higher, a tax professional go higher, an enrolled agent or somebody like me or an attorney, and don't let them into your house unless you absolutely have to.

[00:07:30] Ralph Estep, Jr.: Well, let's move on to number 3. And that's excessive business expenses. Let's talk about my client, John. Now, John was a real estate agent, a successful one at that, and he had a pension for the finer things in life. He had a core belief that to make money, you had to look the part. So John bought designer suits.

[00:07:49] Ralph Estep, Jr.: He drove a luxury car. He dined at the high-end restaurants, all while claiming these as business expenses. You know, he was putting them all on his tax return. Well guess what? John's lavish lifestyle caught up with him when the IRS flagged his return for audit. What did the IRS do? They combed through his receipts, and it became clear to them that many of his expenses that he called business were actually personal. Well, what was the result?

[00:08:14] Ralph Estep, Jr.: As you could have guessed. John faced a hefty tax bill. They nailed him with penalty and interest. And he learned while some business expenses are legitimate, they got to be ordinary and necessary for them to work. That Rolex that he put on his tax return, just wasn't a justifiable business expense. It's not going to work. So that was the big lesson here.

[00:08:35] Ralph Estep, Jr.: They got to be ordinary and necessary. Well, let's move on to the next thing and that's number 4 and that's what we call cash heavy businesses. So let's meet my client, Lisa. She owns a small bakery. Her pastries were hit. Everybody loved her. Her business was booming. But the problem was Lisa would pocket some of the cash she got. You know, somebody come in and buy a Danish or coffee and that money just didn't get to the register. It ended up in her pocket. Which means they weren't recorded either.

[00:09:02] Ralph Estep, Jr.: So one day, just like my other client, an IRS agent showed up at her bakery. They had done some homework before they got there, and they noticed her lifestyle didn't match her report and income. Look, they looked at her tax returns and they saw that she wasn't reporting a whole lot of income. They dug in deep, and they found discrepancies.

[00:09:19] Ralph Estep, Jr.: And now, listen, here's the thing. What Lisa did, that was an absolute disaster. Not only was Lisa not recording those deposits, but she also wasn’t reporting those sales, she was taking that cash and putting it in the bank. So the IRS pulled her bank statements, unbeknownst to her, went to the bank and got a subpoena for them. Added up all her deposit and said, wait a minute, on your tax return, you all reported

[00:09:42] Ralph Estep, Jr.: Let's just say $200,000 in sales. But you deposited $300,000 in money in the bank. How does that work? That's a huge red flag. And Lisa ended up facing some serious consequences. They nailed her with substantial fines. And to be truthful, I'm surprised they didn't, but they talked about criminal charges for tax evasion.

[00:10:05] Ralph Estep, Jr.: So what's the takeaway with this? Listen, if you run a cash heavy business, you've got to keep meticulous records and report all your income. The truth is the IRS has ways of estimating what your income should be based on similar businesses. They have the data and they're going to use it. I had an example of this in my own practice again. There was a pizza shop down at the beach. And this pizza shop, unbeknownst to me, wasn't telling me that they had cash sales. And guess what? The IRS got their 1099-K form.

[00:10:36] Ralph Estep, Jr.: If you don't know what that is, at the end of the year, anytime you have a credit card processing company, there's a 1099-K that's reported that shows all those credit card charges. Well, the IRS got that report as they're supposed to, and they compared it to what was reported on the client's tax return.

[00:10:53] Ralph Estep, Jr.: Well, guess what? What was reported on that 1099-K for credit card sales was exactly what was reported on the 1099-K. So there was no notice of, hey, did you ever get any money in that was paid for cash? And when somebody comes in and pays cash for a pizza? Well, they visited my client. The IRS did.

[00:11:12] Ralph Estep, Jr.: And I think in fact, this one was a state audit actually now that I think about it. The state auditor went out there and visited them. They said, hey, I'm going to buy a pizza. And it gave him $20 and said, hey, you paid for it with cash. And any auditor was pretty slick said to the client said, hey, do you report those?

[00:11:26] Ralph Estep, Jr.: And the client said, oh, you know what, actually, what we do is we use that cash to pay out, you know, for the bread guy in this and that. He was stone cold busted. So if you've got a heavy cash operation, you got to make sure you're reporting that cash. Let's move on to number 5. And that's claiming hobby losses. So let's talk about my client, Bob.

[00:11:46] Ralph Estep, Jr.: Now, Bob was an avid photographer, and he decided, hey, I really like doing this photography work and he turned his passion into a business. And every year, Bob would buy the newest cameras, he'd buy the coolest stuff. He had the best software and every year he claimed a loss in his photography business.

[00:12:01] Ralph Estep, Jr.: Now at the same time, it's a funny thing. He was continuing to work as a full-time accountant. Well, the IRS saw this and they saw his what they call perpetual losses. And again, they decide to dig in a little deeper. They audited him. They discovered that Bob rarely did any marketing. They looked and said, are there any advertisements?

[00:12:19] Ralph Estep, Jr.: They looked at social media. They also asked Bob if he had a business plan. And then when they asked about his customers, Bob said, I deal mostly with friends and family, and I do it for free. That was the wrong answer because the IRS determined that Bob's photography business was a hobby. It wasn't a business.

[00:12:36] Ralph Estep, Jr.: And guess what? If it's a hobby, you can't take the loss and say disallowed all those losses. And Bob had to pay back taxes. He had to be, you know, he had to figure out a way to pay back those penalties and interest. So remember this, this is the takeaway from this. If you have an activity, you've got to run it like a business.

[00:12:56] Ralph Estep, Jr.: There has to be what they call a for-profit motive. And if you're continuing to have losses year after year, after year, you're going to get audited. So that's another big red flag. Let's move on to number 6. And that's what I call large charitable donations. Let me tell you about Amy and Mike. They were clients of mine as well.

[00:13:13] Ralph Estep, Jr.: They're a generous couple and they love supporting our local church and they, they did a lot of things for various animal shelters and all that. And at one point, they decided they had this old car. I mean, this thing was beat. And they decided, well, we're going to donate this old car. Now they thought, ah, you know, and if we want to sell this, we might be able to get about four or 5,000, but hey, you know what?

[00:13:32] Ralph Estep, Jr.: We can just say it's worth $10,000. And that's what they put on their tax return. Now they had done their own tax return at the time they came in to see me later and they put it on there. They thought that's what it was where they hadn't gotten appraisal. But they didn't realize that this large donation relative to their income was going to catch the IRS's attention to red flags went off.

[00:13:52] Ralph Estep, Jr.: So they got audited. The IRS did their homework, and they found out that the actual fair market value of that car was $3,000. So it wasn't more 10 grand. So they had overstated this charitable contribution by $7,000. Well, what happened? Well, Amy and Mike had to pay back taxes. They paid a penalty and interest. So what's the lesson here?

[00:14:15] Ralph Estep, Jr.: It's you've got to get proper documentation for your charitable contributions especially those non-cash items. If something is valuable, the best advice I can give you, and this is within the IRS code, if it's worth more than $5,000, you've got to get a professional appraisal by somebody who is recognized by the IRS as being a professional appraiser. So again, watch out for that one big red flag.

[00:14:39] Ralph Estep, Jr.: Let's move on to number 7 and that's rental property losses. Let's talk about my client, Emma. Emma was doing well in life. She bought a beach house. She thought this would be a great investment property. And what she did was she rented it out occasionally. But the truth is when I talked to Emma, she used it mostly for family vacations. But when she did her taxes again, this is somebody did her taxes before she came to me, and she would claim these losses on her rental property because frankly she wasn't getting much income in, but she had the interest that she was paying the property taxes, the maintenance fees, the HOA's. You know, all those things. And she was showing these significant losses. Well, the IRS again, red flag goes up. They audited her return. And what they found was that this rental property was mostly used for personal use. What the IRS code allows, you can use it personally for 14 days or 10% of the rental days, whichever is greater. And what ended up happening is Emma couldn't claim her rental losses. And that was huge because she had done this year after year. So she had to go back and pay back taxes for several years. They charged her interest, they charged her penalties, what they call, the error penalty or whatever you want to call it.

[00:15:50] Ralph Estep, Jr.: They went after her. So what's the moral here? The truth is rental properties are complex. You've got to understand them before claiming those deductions. That's an area where you need to enlist the services of a tax pro like me. And let's look at number 8, that's the final one. And this one cracks me up every time I think about it.

[00:16:08] Ralph Estep, Jr.: And it's round numbers. So let me tell you, and this wasn't a client of mine. This is one I read about from another colleague of mine on Facebook. And this guy's name was David. Now he was a small business owner. And like most small business owners, he was always rushing around to get everything time. Get everything done and it came time to do his taxes. And David said, you know what?

[00:16:26] Ralph Estep, Jr.: I don't have time to go add up all those receipts. I don't have time to add those things. So he just estimated, and he rounded them to the nearest hundred dollars. So he had, you know, for example, office supplies, 500 bucks. Travel expenses, a thousand bucks. Marketing, $1,500 and so on and so forth. Well the IRS again, they looked at his return.

[00:16:45] Ralph Estep, Jr.: They thought it was really suspicious that everything was a round number. So what did they do? They audited him. And here's the problem. The first thing they said to David is, okay, we got your return, but we want you to provide exact documentation for each of those expenses. We want to receive the receipts. Well guess what? David didn't have them. And when he actually went back and added up his receipts, his numbers were way off. So what's the takeaway? You've got to keep accurate records.

[00:17:11] Ralph Estep, Jr.: You got to report the exact amounts. I've had clients come in to me and they say, Ralph, I have this one, one particular real estate client. And every year, and I'm not going to say he or she, cause I don't want to give it away, but they will come in every year, and they say, okay, you know, what did you pay for marketing?

[00:17:26] Ralph Estep, Jr.: Let's put 1500. What did you pay for this? Let's put 1200. It doesn't work. You have to not do that because the IRS wants you to have accurate records. They want you to report the exact amounts. If not, it's a big red flag. So now we've covered these common audit triggers, let's talk about some strategies to avoid an audit. And the first one is this. Number 1, be honest and accurate.

[00:17:46] Ralph Estep, Jr.: You can take legitimate deductions. The second thing, keep detailed records. You need to save those receipts, those bank statements, all that documentation. Double check your math. This is a no brainer. Simple math errors can trigger an audit. Be consistent. If you are doing one thing in one year, do the same in the next and so on and so forth because the IRS will look at any fluctuations or changes. A big one. Use tax preparation software or consult with a tax professional like me.

[00:18:13] Ralph Estep, Jr.: We can help you avoid those mistakes. If you've got a complex tax situation, you might even think about attaching an explanation to the return. Another big one a lot of people don't think about is file on time because the truth is statistics show that late returns are more likely to be scrutinized.

[00:18:31] Ralph Estep, Jr.: And here, the last one I want to put on lists of things you got to do. If you receive a notice from the IRS, respond promptly and respond thoroughly, and I'm going to say, hire somebody to help you, because this is a truth, an audit doesn't always mean you've done something wrong. Sometimes the IRS just needs clarification or some additional information. But those audit things can be stressful.

[00:18:53] Ralph Estep, Jr.: They're time consuming and you'll want to avoid it if it's all possible. Well, let me do a quick recap. You know, we talked about those 8 most common reasons for an IRS audit. We talked about how to avoid them. The big ones we talked about was unreported income, rounding numbers, all of these triggered red flags.

[00:19:08] Ralph Estep, Jr.: So I reinforced you'll look at honesty, be accurate, have good record keeping. These are really your best offenses in an audit. So tomorrow's show, we're going to talk about 7 money mistakes made by those over 50. So if you're 50 or getting closer, maybe a little bit past that, like I'll be 52 in a week or so, it's going to be a great show to talk about how to approach those golden years.

[00:19:31] Ralph Estep, Jr.: If you're feeling overwhelmed, if you've been audited, or worried about getting audited, your records are a mess, if you've got those tax concerns or maybe some financial matters, I can help you. The best way for me to help you is to schedule an appointment with me and go to askralphpodcast.com/store. I'm going to charge you $150 for a consultation, and I'm going to work with you to improve your finances.

[00:19:52] Ralph Estep, Jr.: Maybe I'm going to help you with your business finances. Maybe we're going to talk about growing your business. I am going to, at the end of the day, my goal is to help you achieve all of your financial goals. We can work together to create a personalized plan that's going to put you on a path to financial success but more importantly, peace of mind.

[00:20:09] Ralph Estep, Jr.: Remember this. My passion is to help you achieve financial success. I want you to live out your dreams. I want you to grow in your faith and I know together we can master your finances from a Christian perspective. So as I always end the show, I want to tell you this. Stay financially savvy, and God bless you.