I hate red flags! Just talking about them makes my skin crawl.
It happens all too often when I meet with a new client. First, we begin discussing their past tax returns and their income streams. Then, we go over their deductions and changes that were made during the past year, and, of course, why they’re looking for a new CPA. Inevitably, they say they don’t want any red flags on their returns based on warnings from their old preparer.
What Are Red Flags, Anyway?
The term indicates areas of caution or concern. The IRS utilizes them when scrutinizing tax returns and determining which ones to audit. A simple internet search will bring up a plethora of audit-worthy red flags. But beware, if you do get audited, the IRS will move into your house, lift up the couch cushions, and steal your pennies.
In all seriousness, while an audit by the IRS isn’t anyone’s idea of a vacation, sometimes preparers use it to either cover up their lack of knowledge. Alternatively, they do it to avoid telling their client no.
Common Irritating Red Flags
The Unknown: These are items born out of poor statistics. But, sometimes preparers use them to mask their poor knowledge surrounding the tax code. Typically, a preparer will scare a client into not taking a deduction because they don’t know the rules regarding whether or not the taxpayer can rightfully take the deduction and don’t want to make a mistake.
|The IRS will target those with incomes over $200,000.||While this may be statistically true, I have seen high-income earners scared about taking mortgage interest on their home, even properly documented on a Form 1098 to avoid an audit. The statistics here are likely a result of the multiple income streams of high earners rather than the income dollar amount.||Make as much money as you can. With a progressive tax structure your bank account will be higher at the end of the day.|
|Starting a Business||
Business is complicated. It changes your return significantly. What do you do with your car, cell phone and other expenses that benefit both personal and business life? If your preparer says this will catch the eye of the IRS, they don’t know how to advise you.
This is dream-crushing, adding to the already scary thought of starting a business, and keeps them in jobs they hate.
|Go for it! Start a business and to take a line from the Greatest Showman: “Live with your eyes wide open.” Hire a bookkeeper, document your receipts and track your income. You are running a business; act accordingly.|
|Claiming a rental loss||Once again, your preparer doesn’t know the rules. Are you passive or active in the business? It gets quite complicated, but that shouldn’t make you pay more in taxes. I’ve seen taxpayers that were scared to list all of their repair costs, or leave off utilities that they paid for just to show a profit on a rental property. They were scared that if they lost money they would be audited.||Having extensively worked in the real estate market, there are very few rental properties that have taxable income (positive cash flow is not necessarily income) in their first year or even after a few years. Once again, you are running a business; get a bookkeeper, properly document the activity, and claim your full loss.|
|Deducting business meals, travel and entertainment||I can’t speak for all CPAs, but my experience in audits of this nature really boil down to lack of documentation and poor planning instead of invalid business activity (they do exist though). In order to claim this deduction, you need an itemized receipt, who attended the activity and why. The cautionary tale is that the majority of people and businesses do a poor job in documenting. So in case of audit; it’s an easy win (and a no brainer) for an agent to disallow something with no support.||
In at least 2018 through 2025, entertainment related activities are nondeductible.
In regards to meals and travel, keep receipts, document who was there and why. If you have the support, welcome the IRS with open arms and get them a cup of coffee; they will be there a while.
|You give a lot of money to charity||Really! Are we really scared into being less generous? That is just ridiculous. If your preparer is telling you this, just walk away.||We shouldn’t be giving money to charity purely to get a tax deduction, but rather it’s a thank you from the government for helping others. Don’t give cash and keep your records.|
|Using digital currency||There is plenty of guidance and reports on how to treat cryptocurrency. So, if your tax preparer doesn’t know how to treat it or wants to find the path of least resistance, ask some more questions to make sure they can explain it to you.||I am not a financial advisor, so if you believe that digital currency is the future or if you just want to try and make a buck by trading, go for it. But, talk to your preparer to make sure you understand the consequences of doing so; preferably before instead of after.|
These are violations of the Internal Revenue Code. Some can happen accidentally or innocently, but regardless, they could result in an audit. If you do one of these, you will almost certainly get a letter, if not an audit as a result. It’s inevitable that the government will track you down.
|Not reporting all of your income||This can happen innocently or deliberately. Deliberately may land you in jail. But, if you just made a mistake you aren’t in trouble, you just owe more in tax than you originally thought.||Be diligent in keeping your records and saving your tax forms. Before you submit your documents to your CPA or submit your return, review them to make sure everything is accounted for.|
|Failing to report a foreign bank account||The rules get complicated and the penalties are severe. If you have financial assets overseas, the IRS needs you to report the maximum value during the year if it’s over $10,000 USD. Anything other than compliance spells trouble.||Once again, choosing not to report something that the government is asking for is looking for trouble. Being compliant here will save you money and your sanity.|
Let Root Tax Take Care of It
If your tax preparer, neighbor, friend, or spouse starts talking about red flags this tax season, tell them to reach out to us.