Often we get asked: “If I claim (fill in the blank), is it a red flag?” Our response is usually a long winded explanation ending with, “it depends”. The truth is, the IRS’s formula for selecting returns to audit is a well kept secret. Some returns are selected completely by random, and others are scored for audit based on an internally developed rating system. The returns that score highest are reviewed and if they look like good candidates, they are sent to either a regional office for an audit by mail, or a local office for a face to face throwdown. Nobody knows exactly what will set off alarms at IRS, but there are some things you can be mindful of that will limit your likelihood of having to deal with any imperial entanglements.
First, make doubly sure you claim ALL your income that is disclosed on a 1099 form. IRS is very efficient at matching these to returns and will generate notices automatically when they do not find what they expect to see on your return. This is low hanging fruit for them as it is all handled by computer.
Second, avoid large negative numbers from your sole proprietorship. If your Schedule C is negative, you must be prepared to clearly support all of your costs here with evidence that they were “ordinary and necessary” business costs AND prove that you really paid them. A real accounting system instead of a shoebox full of paper scraps will help a lot when you are asked to produce records. Be prepared to prove that you are running a legit business instead of trying to deduct a hobby or scam.
Have a rental property? Large numbers for maintenance and repairs will invite scrutiny as many times these cost are more properly capitalized and depreciated over time.
Do you have a lot of unreimbursed employee expenses? If you incur job related costs that are not covered by your employer, they may be questioned if they have a large impact on your tax. You will need to be able to prove that they were clearly job related and explain why they weren’t reimbursed by your employer.
If legit, you should not back away from claiming deductions that are so called red flags. But, unless you want to be hoisting a white flag at audit time you must prepare for it when you prepare your return.