Don’t risk and audit unnecessarily! Sometimes the red flags are unavoidable due to the fact that you claim all the deductions you’re entitled to and you should. Just be sure you have adequate backup for taking them.
The most common red flags are:
Travel and Entertainment -Meals and entertainment are only 50% deductible. The IRS is aware that many taxpayers throw personal expenses in here. Be sure that you document the client and the business purpose of the action that you incurred this expenses for.
Depreciation of Listed Property -If you purchase equipment that can be used both for personal and business be sure that you document business vs personal use. Items usually subject to this are home computers, cars, telephone, televisions, camcorders, VCR’s, and photographic equipment. Again have proper documentation and you can beat this if audited.
High Interest Expense on Individual Returns - Personal interest is not deductible and investment interest is only deductibe to the extent of investment income. If you are one of the taxpayers that are playing the shell game with this to make it deductible beware. Credit card interest is not investment interest and personal auto loans are not deductible. If you have substantial interest expense that is claimed on your tax return other than mortgage be ready to prove it.
Unreported Income - Don’t even attempt to not report income that is recorded on a W-2 or 1099. This is reported to the government and it is matched up on your return so your chances of getting away with this are poor and may trigger a full blown audit.
Unusually High Itemized Deductions - The IRS computer may flag your return if you have unusually large deductions for your income category. This doesn’t mean don’t take deductions you have coming to you, just be sure that you have all your ducks in a row when it comes to substantiate them.
High Miscellaneous Deductions - To avoid the 2% of AGI limitation on itemized deductions some taxpayers have been known to shift them onto a Schedule C or Schedule F. This is a problem and can flag your return. Be sure that you categorize your miscellaneous deductions for Schedule A rather than throw a lump sum amount on your return. Such as investment fees, safe-deposit box, tax preparation and planning and so on.
Side Business Losses- Hobby or business! Be sure that you know the rules here. Under the hobby loss rules, you can deduct expenses only to the extent of income generated by it. However, if the side business generates atleast some profit in 3 out of 5 years (2 out of 7 for raising horses), you can generally consider it a business and not a hobby.
Early Retirement Plan Distributions- Taxpayers drawing from qualified retirement plans before age 59 1/2 are generally subject to the 10% penalty on the withdrawl. However if they are disabled, the distribution is due to their death, or benefits are paid out as an annuity over their remaining life expectancy the penalty doesn’t apply. The 10% penalty also does not apply to IRA withdrawls used for qualified education expenses, certain home-buying expenses and unreimbursed medical expenses in excess of 7.5% of AGI or to unemployed persons who use the IRA withdrawls for medical insurance premiums.
So the moral of the story is please treat all deductions the same: that is make sure you can back them up with documentation. No deductions are completely safe, but some are safer than others.
Safe deductions - mortgage interest, real estate taxes, state income taxes, exemptions for your own children, union and professional dues, cost of professional journals, drugs and medical expenses, safe deposit box rentals, and tax preparation.