Every year around this time, many tax payers and tax professionals express a heightened curiosity regarding the possible factors that might trigger a future IRS tax audit.
As if searching for the Holy Grail of finance, for many it seems the quest to identify and avoid the proverbial "red flags" that increase the chances of IRS scrutiny will protect them from evil, provide them with special powers and reward them with health, happiness, and prosperity in infinite abundance.
Rather than focusing exclusively on these potential "red flags", perhaps it might be wise and more instructive to consider a different more holistic perspective when tying to predict and prepare for possible future IRS behavior as represented by this red white and blue flag?
WHAT SIGNALS ARE YOU SENDING THE IRS?
Are you inadvertently telling the IRS you are looking for a fight? Inviting them to take a closer look? Are you waving a red flag or something else?
Interestingly, the origination and modern uses of the term "red flag" varies but the 1602 Oxfod English Dictionary cites its use by military forces preparing for battle. Seeking conflict if you will.
A Naval Encounter between Dutch and Spanish Warships by Cornelis Verbeeck. c. 1618/1620. A solid red flag, signifying the ship’s intent to engage in combat with a Spanish galleon (left ship), flies at the Dutch warship's stern (right ship)
Thus in keeping with the early nautical idiom, an alternative to IRS red flags, one may want to think of the nautical signal flag for the letter "W" or Whiskey. It is comprised not just of the color red, but three colors - red, white, and blue. Likewise it might serve as a convenient reminder of three elemental factors - each starting with the letter "W" that could be helpful in predicting and avoiding possible future adverse IRS actions.
And while this discussion is appropriate for every tax payer, there are certainly many affluent yacht owners wondering what they may do to avoid a proverbial future catastrophic collision course with the IRS.
Can just taking all the tax deductions you are entitled be a potential red flag to the IRS?
Many speculate and guess about the possible factors that may precipitate an initial IRS inquiry, but actually for many that's probably not even the most important question.
Research confirms that very few of the most affluent tax payers take full advantage of all of the available tax incentives and benefits Congress has included in the tax code. The evidence suggest this may be due to frequent changes in the tax code, the constantly evolving interpretation of existing regulations by the IRS and courts, and the lack of knowledge by tax professionals.
However, it is indisputable that whether correct or not, many tax payers and tax professionals believe that one's DIF score as explained by the IRS, how much a tax return differs from one's peers, plays a significant role in determining which returns the IRS reviews.
As a result, many tax payers fail to take full advantage of the benefits legitimately available for fear of being "too different" from the average and possibly attracting IRS scrutiny.
Understandably, even though tax professionals advise taking all the deductions one is entitled, many tax payers over pay their taxes- sometimes substantially- simply as the cost of convenience. For many, it's simply not worth the worry - if taking all their deductions could put them at higher risk of an IRS audit.
Perhaps the optimal solution is to take all the deductions your are entitled as Congress intended and not worry about any possible red flags that may prompt an IRS inquiry.
Rather it's wise to focus on what signals you will send the IRS after their notice.
WHO DOES THE IRS TARGET?
Well documented budget cuts have reduced available IRS enforcement resources so the total number of actual audits is relatively low by historical standards. IRS resources have not kept up with the population growth. But that is not necessarily good news for some tax payers.
The IRS is just like any person or any organization with finite resources and objectives to achieve - they seek to maximize their return on investment. They want the most bang for the buck, the low hanging fruit will be picked first. So the IRS must have a priority list.