Six Items that Could Trigger an IRS Audit
From: www.wealthmanagement.com
Wealthy individuals with a red flag on their tax returns are more at risk.
The Internal Revenue Service recently announced its plans to significantly increase audits on the wealthiest taxpayers, large corporations and large, complex partnerships for tax year 2026.
Audit rates will rise by more than 50% for those with total positive income over $10 million (up from an 11% coverage rate in 2019 to 16.5% in tax year 2026). That news is sure to trigger anxiety in some high-net-worth earners.
But an IRS audit is more of an exercise that seeks documentation; it’s not necessarily an accusatory event. They just want to see your clients’ homework to show how they got their answers.
Dot i’s, Cross t’s
Taxpayers should be able to explain and justify their tax positions and investments to the IRS. Proper documentation is crucial, and I advise clients to prioritize it. I tell them to make a note of what they do and when they do it. This way, they have their homework in place and ready to show the IRS if it’s needed. They should start a file or folder that includes all the forms and documents that explain their financial actions.
The documentation should answer these questions:
- What did you do?
- How did you do it?
- Why did you do it? And;
- What documents do you have that support what you did?
Some of the wealthiest people are inherently risk-takers. Translating this to tax planning, they aim to take a calculated risk and say, “Do I have a position here? Can I document this position that gives me the ability to make an argument to the IRS on why this position works? Do I have enough documentation to support it?”
Next time a client hears the word “audit,” they should consider it a tool that IRS employees use to check their homework. Make sure they did theirs.
Practices that Could Trigger an Audit
While there are many honest reasons someone might omit or forget some income received, those instances rarely border on criminal or wrongful intent. But illegal practices, such as fabricating documents, taking deductions that aren’t allowed or making up different types of expenses that didn’t occur, can spell trouble.
Here are six items that could draw the IRS’ attention:
1. Listed Transactions
These are transactions the IRS has identified as potentially abusive. They’re the same or substantially like those that the IRS has determined to be a tax-avoidance transaction.
2. IRS “Dirty Dozen” List
This is a list published annually by the IRS highlighting common tax scams and abusive transactions. Tax professionals advising clients on aggressive tax strategies or helping them navigate one of the items on the listed transactions or dirty dozen list have to file a material advisor form. That means the tax professional materially advised the client to do something that’s considered aggressive in the eyes of the IRS. In effect, the form alerts the IRS to scrutinize those clients.
3. Active vs. Passive Losses
Many taxpayers incorrectly use passive losses to offset active income (like wages). The IRS considers a passive business or trade activity one in which an individual doesn’t materially participate – for example, the individual isn’t involved in the operation on a regular or substantial basis. Popular passive activities include rental real estate, equipment leasing, limited partnerships and limited liability companies. But passive losses can be written off only against passive gains.
4. Missing Income
Most of the causes behind an audit stem from an error or omission. If a client didn’t include all the income that they received and should report, the government might have questions. In some cases, not all the Form 1099s or K-1s get turned in. This is easy for the IRS to catch because of tax forms that employers and financial institutions send to the agency, such as the aforementioned ones or investment earnings on Form 1099-B. If a client fails to report such income, the IRS will notice the mismatched data.
5. Partnerships
The IRS is focused on partnerships that don’t pay corporate income taxes. Tiered partnerships, or those that own another one, can provide a way of hiding income.
6. Estate and Gift Tax Exemptions
The 2017 Tax Cuts and Jobs Act, which will expire at the end of 2025, includes a higher federal gift and estate tax exemption, allowing more wealthy Americans to transfer tax-free assets to the next generation. However, those who use aggressive valuation discounts for assets could trigger an audit.
