Every year there are “red flags” that prompt the IRS computers to pull returns for a closer review. The IRS recently hired more agents for collections, and in turn, revenue officers who will contact the taxpayers by first class mail and certified mail if no response. The IRS will never call you unless you are in conversation with them about a specific year/issue.
The 2022 list is out! Here are the top ten red flags to be wary of this year:
#1 Education Credits:
There are currently two higher education credits available to taxpayers: The American Opportunity Credit, available only for the first four years of higher education, and the Lifetime Learning Credit. Both have credit and income limits attached.
RED FLAG: Claiming the incorrect credit or claiming both credits in the same year for the same student. This can be yourself, a spouse, or dependent(s).
#2 Having a Small Business:
Cash-intensive businesses are under more scrutiny from the service as there is a larger chance of underreporting income or over-reporting expenses.
- If an S Corporation takes wages that are too low
- Deductions as a percentage of income that do not fit into the matrix for the industry
- Not recording debt forgiveness as income (credit card, defaulted bank loans, etc.)
- Co-mingling business and personal income and expenses in one bank account
- Most notably this happens to sole proprietors who are unaware that they need to keep each separate in their own accounts
- Large business mileage, travel, and/or meal expenses without substantiation by mileage/trip logs stating the purpose of the trip, total business miles if applicable, or receipts showing client name and purpose of the meal expense
- Note: this one is an all-time favorite that appears every year for most small businesses
#3 Advanced Child or Dependent Care Credit for 2022:
In 2022, we saw an increase in the child or dependent care credit. Parents of children under the age of 6 received a $3600 refundable credit, while parents of children aged from 6 to 17 received a $3000 refundable credit.
RED FLAG: One-half of the credit was paid through last year and needed to be reconciled on the 2021 return. So, if a dependent was not on the 2021 return but credit was received, those advances need to be repaid.
We saw an increase in cryptocurrency in the last couple of years. An estimated 106 million people around the world use cryptocurrencies as of 2021, roughly 22% of that number in the United States, or 46 million.
RED FLAG: Any exchange of cryptocurrency must be reported as if it were a sale of stocks, bonds, or other capital assets. Failing to report properly or not at all causes review and audit.
#5 Claiming the Earned Income Credit:
The Earned Income Tax Credit is a refundable credit for low-income taxpayers with dependents. If you owe no income taxes, you would still get all or part of the money.
RED FLAGS: Examples are under/over-stating income to reach the maximum credit, claiming children that do not reside within your household, using the incorrect filing status, and married individuals each filing head of household and splitting the children to get maximum credit.
#6 Large Gifts to Charities:
A deduction as an itemized item is allowed for all cash deductions. Likewise, gifts of goods may be claimed on Schedule A.
RED FLAGS: Overtly large deductions for non-gifts or cash gifts that seem unreasonable for the household income would generate a correspondence audit requesting proof of receipts and letters from non-profit organizations. Gifts to individuals, such as Go-Fund-Me or healthcare sharing, are not charities and are not allowed as a deduction.
#7 Rental Income:
Rental income itself is not a true target of audit or review, but with the rise of Airbnb/VRBO, more individuals are getting into the rental business. Rental losses may not all be deductible based on income and the amount of the loss.
RED FLAGS: AirBnB and VRBO both send 1099s to the owners of the properties and to the IRS reporting the amount of income for the year. Overstating expenses to generate a loss in order to reduce taxable income may generate a correspondence audit or review requesting copies of receipts and proof of expenses. Most problematic are landlords that rent a room or a garage/basement apartment and take more than the percentage of household expenses for the rental use.
#8 Office in Home Deduction:
This is a legitimate deduction for the self-employed individuals who have dedicated space in their homes for their office or storage space for goods for resale. To take the deduction, the self-employed individual must have a profit and attach the required forms.
RED FLAGS: Having W2 income and working from home while “claiming” a business in order to take the deductions that were removed from the Itemized Deductions on Schedule A in the 2018 tax reform bill. Working from home due to COVID restrictions does not qualify for this deduction. Overstating false income to wipe out other income would be a reason for an audit.
#9 IRA/401K Withdrawals:
Taking funds from an IRA or 401K is a taxable event. If the taxpayer is under 59.5 years of age, and there are no known exceptions, they would pay a 10% penalty on top of the income tax owed.
RED FLAGS: Not reporting the withdrawal. Roth IRAs may not be taxable if certain rules are met, but the distribution must still be reported and indicated as non-taxable. The IRS will receive a copy of the 1099R and will look to match the amounts to the tax return.
#10 Healthcare Premium Credit:
In 2020, the IRS forgave any overpayment towards the subsidies for Healthcare through HealthCare.Gov. In 2021, the old rules applied, that if you received insurance through healthcare.gov, even if no subsidy was given, the form must be included on the tax return.
RED FLAGS: Filing Married Filing Separately to avoid repayment due to lower household income. Failing to provide form 8962 along with your tax return when insurance was purchased through the exchange, or not including income such as unemployment or Social Security Benefits as part of household income.