IRS Red Flags Explained: When to Push and When to Protect

Kevin: [00:00:00] So if you've ever been around tax for any extended period of time, filed your own tax return, Googled any taxes at all, you've come across a term red flag and. What is a red flag? What does it do? Well, we're gonna go over some of the top red flags that the IRS are looking for and how to avoid 'em. And you can't avoid every red flag.

Kevin: And just because it's a red flag doesn't mean you should veer away from it. A lot of tax planning is red flags. If you've never done tax planning in your past and, and you come to a um, A CPA and they actually strategize for wants and reduce your taxes by like half, that's a red flag. That's okay. It's defendable, it's legal.

Kevin: It's, that's okay. But what we don't want is unnecessary red [00:01:00]flags. Mm-hmm. Which we're gonna go through here. 

Mike: Yes. We 

Kevin: are 

Mike: just getting to the term red flag. You know, it's something that. I don't think in any of my tax courses in college or on the CPA exam, they actually taught. It's like more of this vernacular.

Mike: It's just around what I believe most people are referring to with a red flag. I don't want any red flags is something that you put on a tax return that's gonna greatly increase the likelihood that the IRS is gonna wanna look at it and dig deeper into it. Right. Um, but like you said, a lot of the tax claim that we do.

Mike: Will likely cause IRS to dig deeper into it. Um, anytime you you file, you amend a tax return for a refund. That's a big red flag. If you amend a tax return that's already even filed to reduce your taxes, more than likely you are doubling your risk of getting audited. But let's say you made a mistake on your first return and you paid too much taxes and you need to amend it, should you not amend it?

Mike: Heck no. Just be ready and be cognizant. If you're [00:02:00] filing a return with a red flag, be ready to defend it. Don't be scared. To the IRS. That's, that's, that's how they try to get you to pay more taxes than you're legally obligated to pay. They say, we're gonna come after you, so you better pay too much taxes.

Mike: Don't cow to the IRS. That's not being a good steward of the money that you've been given by God. From your hard effort, take back what is rightfully yours. Please don't be scared. The IRS just be ready to defeat them if they come after you. 

Kevin: Yeah, and I would say red flags. Um. From our standpoint, whenever we see a client come in new, uh, for us, and we look at their prior tax returns that they self filed, one of the biggest things that I see are nice, like big fat round numbers on there.

Kevin: Like someone's filling out a Schedule CI. They, you know, they maybe had a side gig or doing something on the side and they didn't have proper accounting records. They did not, um, hold any receipts. They did not have a different bank account, [00:03:00] so everything was run through their personal account. So what they did, they were like, uh, okay, I think I made about $10,000 I spent.

Kevin: Three grand on a computer. So yeah, I'll put 3000 for the computer. My, 

Mike: I drove 1000 business miles. Exactly, exactly 

Kevin: 1000 business miles. My cell phone was $900 even. And then you file a tax return with a bunch of zeros and fives. No, don't do that. Uh, because what the IRS is looking for is low hanging fruit.

Kevin: What their job is, is they want to find mistakes on a tax return quickly and something that's gonna be material. Um, now material could be different for them and us, but what they want is they want low hanging fruit that they know they can go in. They're like, oh my gosh, look at this Schedule C. It's just a bunch of zeros.

Kevin: They obviously kind of just threw a dart or they just put it together real quick and they're nice and round. And even if we challenge it, even if there was round numbers or somewhere in that ballpark of a computer was $3,000 in your tax return, but you actually paid [00:04:00] $3,254, whatever. Um, maybe that was the actual cost, but.

Kevin: More than likely you can't hack that up. 'cause you, if you're quick to put the three grand on there, you're quick to also throw away a receipt invoice or even find that in your bank statement so they know they, that's an easy audit to go in there. 'cause the burden of proof is gonna be on the taxpayer. So if just stick, stay away from round numbers.

Kevin: Uh, actually do legit accounting if possible. But stay away from the round numbers. Yeah. 

Mike: Um, so many times we've seen that there's been times where our clients legitimately have a big round number and I convinced them to, even though they'd get a $5,000 even deduction, only take 494,992. Um. Just to reduce the likelihood.

Mike: But again, if it's a round number and you want that deduction, just make sure you have substantiation for it. 

Kevin: Yeah. And a round number where it's okay, charitable giving. Very rarely are you gonna cut a check to your, uh, a charitable organization for $971. Uh, [00:05:00] you're probably gonna just round that to a thousand.

Kevin: Right? I mean, I don't know. That's just human nature. So charitable giving. Probably okay with round numbers, that's very common, but we're talking business expenses on, uh, your tax return. And this not only just for Schedule Cs, but your partnerships for your S Corps as well. Just, 

Mike: you know, another place I see it a lot is on the home office deduction for sole proprietors.

Mike: They'll say they're square. You have to put the square footage your house on that home office deduction for 'em, right? Yeah. They'll say their house is a thousand square feet and their office is 100 square feet. Just say, I'm gonna get 10%. I see that all the time, and it's like, why? 

Kevin: Yeah, 

Mike: just because they, 

Kevin: I don't know.

Kevin: They don't know the square footage of their house. They don't measure out the actual, yeah. I don't know what it is. But the home office deduction itself is a red flag. Yes, it is. Um, and what start, how do you start to understand when a red flag is? You look for areas that taxpayers cheat. Yeah. Where people easily cheat.

Kevin: That is probably where the red flags are gonna be. 'cause the, IS knows that home office [00:06:00] is a very common area to fudge or say, uh, yeah, 50% of my house is business, I promise, or my car's a hundred percent. That's, that's doable. Um, but meals and entertainment. When entertainment was deductible, oh my gosh, it was a free for all.

Kevin: You can just, everything was a business expense. Uh, meals are the same way. Travel's very big too. Um, and then your home office, those are some very big categories that a lot of people try to push, uh, expenses through. Um, so just be careful on that. 

Mike: Be careful. And this is not what the, to the topic of this podcast is Red flags, common Red flags on how to avoid them.

Mike: But let's just talk about, in a little more detail what Kevin was just talking about. You are allowed, legally allowed, and you should deduct every ordinary and necessary business expense you have. If you're filing a business return, just back it up meals. Are a requirement in [00:07:00] so many businesses, um, whether you're having to, to, to dine your, your clients, um, or even take out your team.

Mike: Meals are a reasonable deduction. Just make sure you know what the rules are. Talk to your tax advisor. Um, for meals, you need a receipt or contemporaneous evidence. Um, you can use a credit card statement, but you also need to write down somewhere or notate somewhere the business purpose of the meal. And who is in attendance?

Mike: That's it. Once you have that, you're done. It's legitimate. Who cares if the IRS audits you? It's your deduction you're allowed to take. Don't let them intimidate you. Just show them your documentation. Another big one. I see Kevin. Um, we, we have this happen with a lot of our clients who aren't scrupulous at keeping their tax documents, right.

Mike: Um. You might have a hundred different investments out there over the years, and you're getting dividends sent to you from so many different companies. You have 1 10 99 diviv for like $14 or [00:08:00] $42, whatever, small amount. You don't remember sending that to your taxes preparer, or when you're preparing your taxes, you don't put that in there.

Mike: Anytime someone sends you a 10 99 or a W2 or a K one, they're also sending that to the IRS. The IRS has a computer system, not the greatest, but it works really well for underreporting of income or income matching. They go and look at all the income that was been reported to you and their computers. Look to see if it's on your tax return.

Mike: If it's not on your tax return, like that $42 10 99 div that will. Guarantee IRS scrutiny. Normally it's just the computerized statement. You get automated under reporting notice. Um, they tell you, you reported this. We see this. Fix this. Um, but every time you get one of those, it opens up the possibility that the IRS an agent, a human being at the IRS, is going to get into your details and make your life harder.

Mike: So don't do that. How to [00:09:00] avoid it. It's easy these days. It used to be harder. You'd have to call the IRS request a transcript. The easiest way to do it is open up an IRS account online and before you file your tax return or before you have someone else file your tax return, download a wage and income transcript.

Mike: They will tell you the IRS tells you, Hey, this is all the income we have reported for you. Make sure you're picking all those up. Um. I that could avoid so many notices and so many headaches that we see our clients dealing with. 

Kevin: Yeah. And we almost do this with our high net worth individuals at our firm for, uh, in, when we prepare a tax return as part of our due diligence is because I.

Kevin: This is a, a common problem when you start getting to the wealth that some of our clients are in, where you have money spread out among 30 different entities or 30 different kind of brokerage accounts and they're, you're in different kind of tax advantageous tax. She, you're doing all sorts of different kind of investing.

Kevin: And so a lot of these [00:10:00] times our tax, our clients, our individuals have professionals that are monitoring all that. They don't know which way is up when it comes to their 10 90 nines and where their money is. So we. Just go directly to the source. We pull a wage and income transcript, and we tick and tie that wage and income transcript to the source documents.

Kevin: If we're missing something, we could just report what's directly on the wage, the income transcript. Um, anytime you could prevent correspondence with the IRS, the better. They're like, they're, they're someone you just, you know, they're there. You don't want to talk to them. Um, but they're there and you have to kind of work with them once a year.

Kevin: But other than that. Just make sure you're reporting all your income. Um, another kind of red flag that I see is oftentimes on a Schedule C, you'll report losses and they're, like you mentioned earlier, they're legit losses. I mean, don't, don't be scared to take losses because it's a red flag. Who cares about that?

Kevin: Uh, if it's defendable, which we do on, on the front end, we prepare audit defense for all of our clients [00:11:00] on the front end in case you are audited. 'cause we're doing it at tax planning, that's kind of part of the game, but. Don't be scared to report business losses, but if you report business losses for sub for sequence, maybe like three years, um, the IRS could check under the hood on that because there's hobby loss rules.

Kevin: Um, they wanna make sure you are all right. Are you actually trying to make money? Yeah. I think that's on this, 

Mike: in their computer system. The IRS has this rule and. This is not an absolute, but this is the general rule. If your business shows losses in three outta five years, the IRS is gonna assume it's a hobby and the computers pull it out.

Mike: That doesn't mean it's a hobby. Don't. Again, if it's a business, if you have profit motive, and you can establish that and prove that, take your losses, get those deductions. But if you're showing a loss on your schedule C, three years in a row. Expect some IRS scrutiny on that. Again, don't freak out [00:12:00] about the scrutiny.

Mike: Just be ready for it. Prepare it, have your defense, prepare it ahead, prepare it ahead of time. Uh, as Kevin mentioned, we do that with all of our clients. We prepare the IRS audit defense before we file the return. Make sure you're doing that if you're self preparing and make sure your other tax preparers doing it, if it's not us.

Kevin: Also incomplete tax returns. That'll probably get you in trouble too. So there's a lot of forms and schedules and if you're not so many, dude, if, yeah, if you're not a seasoned. Tax preparer. Um, you're, you're gonna rely a hundred percent on tax software to know what forms are required where, um, but if you're missing any of those forms or missing any schedules, you're gonna get a notice guaranteed.

Kevin: Yeah. And so you have to back up. All the, if, just look at it. If we had to paper file our tax returns these days, I don't even know what the cost of our tax returns would be in this economy. Oh gosh. Just 'cause the bill rates would be so high because we rely heavily on software. Because if you actually look at a tax form, like [00:13:00] a schedule se, it's ref, it's like 30, 40 lines and it's like, okay, go to line three.

Kevin: Line three. Okay. It's line, line one minus line two, and you're. It's, it's all over the place and you have to pull from different schedules. Go to Schedule one, go to Schedule C. Is there anything on Schedule E, compile all that onto a form se take that form se to page two of the ten four. And I'm like, what?

Kevin: What? Um, now we know how the tax forms all flow and work. But we're relying on the software to put everything. And we have reason, reason we have reasonable ways to check if you're DIYing a tax return or got, if you're paper filing a return. My goodness. Make sure every schedule and form is included on there.

Kevin: Math errors are also eliminated with computers, um, typically, um, 

Mike: but that's actually another big one. If. There's errors in meth. Yeah. If you air have errors in meth, you list a whole bunch of expenses, but the total doesn't tie, [00:14:00] um, to the actual math boom. IRS Yep. You're gonna get hit. And just think about a big picture.

Mike: I mean, all really what red flags are is, like Kevin said, we gotta deal with the IRS. Um, they, they aren't your enemy, but they're generally not very helpful to you either. They're their, their intent is not to make your life easier, unfortunately. Um. Put me in charge of the IRS and that will be the intent.

Mike: Make it easier. Just make sure people aren't cheating on, on the tax laws. What happens? The IRS prepare or or processes over a hundred million tax returns each year. If you include all the business returns and information returns, they don't have a hundred million people working there. They're not looking at every single ones.

Mike: Most of it's automated. So if you can keep a human being from having to get involved with your tax return, guess what? If you paper file, a human being has to scan that in before anyone can review it. It's. 

Kevin: They're stamping it. They're looking at it. Don't paper file, if at all possible, ever. Don't paper file, 

Mike: but anytime something pops up in the computer [00:15:00] system says, IRS agent, we need an agent.

Mike: Come look at this. Is this okay? That's when, even if it's a hundred percent legit what you're doing, that's when you're increasing the likelihood of the IRS, um, getting into your business. We try to avoid that as much as we can, and at least know when you're getting into that. So you can easily provide us a response.

Mike: A second, they send you a notice about it. Be ready just to fax it off. The second the day you get that notice, fax it off. You can do it. If you can do things that quickly and give them that answer with your substantiation, your defense. We have closed so many audits before they even started. Mm-hmm. Um, by being able to do that.

Mike: So consider that as well. 

Kevin: Yeah. The other big one that we kinda also see is on this is outside of kind of the 10 40. It's very common to have a hundred percent business use on vehicles. Like if you're, uh, you know, if you have a pool company and you have a fleet of trucks that go around servicing pools and they park it at your facility, [00:16:00] that's a hundred percent business.

Kevin: Use those trucks, there's not much personal use on them. Um, so there, you know, if a plumber or whatever, if you have a fleet of. Trucks or cars or whatever, but. If you're just a sole proprietor and you legit have a reason to write off your vehicle, let's say even an Uber driver, maybe some Uber drivers out there have their own vehicle that they use for work and some they use for home.

Kevin: They have two cars. More than likely they're hustling. They're probably driving the same car they have for personal, as they are for business. So if you take a hundred percent business expense on a vehicle, you also are taken to school, taken to, uh, the movie theater, taken to the grocery store and all that.

Kevin: You have, you can't deduct your personal use of your vehicle. So if you are taking a hundred percent business use on a vehicle, as long as it's legit, do it. Back it up. But. If there is personal use, you have to kind of substantiate that with a mileage log, if at all possible, because that will draw [00:17:00] attention.

Kevin: If you're writing off a big significant vehicle, you have a W2 job, I don't know, whatever your situation is where you're using a personal vehicle, you gotta make sure you're partitioning that. 

Mike: Yeah, it, it truly is a red flag. 'cause vehicles, um, are what's called listed property. You have to file a special form, put in some more information, put in your business use.

Mike: Percentage and mileage. And the IRS knows people had cheated at this a lot. So if you have one vehicle and you're listen to a hundred percent businesses, you better be able to back that up. Um, mileage logs used to be a big pain in, um, years ago, and we had paper logs we used to fill these out, but our odometer readings before and after each trip, those are horrible.

Mike: You don't have to do that now. There are so many apps out there that will track your business miles for you and, um, it's legit backup if the IRS deals with it. But again, if you only. Have one vehicle. You probably don't have a hundred business percent business use. One thing that shocks a lot of people, and they don't realize this 'cause they're like, no, I truly do use this car only for work [00:18:00] anywhere else we go.

Mike: I go, my wife drives us around. Um. If you're taking that car to and from your primary place of business, your office each every day, that personal commute is not business use. And I've seen, we've had clients get hit who claimed a hundred percent business use, and the truth is they only drove it for work, but they drove to and from their office with them that was personally use.

Mike: We had to do it to once you, once you get an IRS notice about a potential audit or they're looking for more information and you say, you know what? You're right, I didn't use a hundred percent. I use it, 92% business that IRS is agent is gonna smell a bone and want to dig more. It's hard to get it to close quickly at that point.

Mike: So be able to back up the stuff and, and if you truly use it for 92% business use. That's what you should be reporting. The the other 8% is not worth the flag. Yeah. And the audit, 

Kevin: you don't want the, you don't want 'em to have blood in the water and start circling because if, if you falsify one [00:19:00] area, it kind of eliminates kind of the, the faith of all the other numbers, right.

Kevin: I mean, it all kind of snowballs. So, um, yeah, just document, be honest, but know, know how to defend yourself too. Um. 

Mike: I mean, if you have business mileage, you ought to be deducting that that's. That's rightfully yours to take. You should take it. Another one I wanna talk about is refundable credits. Um, our last IRS commissioner, or at least from the last administration, we've had a few in the last few months, but Danny Wurfel, um, from the Biden administration got in a lot of trouble for this, um, you know.

Mike: President Biden made these promises. We are only gonna increase audits on the richest people in the world. But then, I think it was the New York Times did this, did this, um, investigation. It turned out that most of the people getting audited were people who applied for the earned income credit, which tends, and it has to be the way the tax law is, those are lower income individuals [00:20:00] and.

Mike: Uh, and they're minority too. The majority of the people claiming that EIC according to that article were minorities. And so Wrf got in this big trouble 'cause he was in front of Congress and they were, they were hitting him hard about it. Um, you said you're not gonna increase auto rates on, on anyone, but the most rich.

Mike: But here you are going after the poorest and the minority community with the earned income credit. Um, the fact of the matter is, is IRS is found and that's why they're doing it. They have found that. People cheat a lot on the earned income tax credit. They cheat a lot on refundable credits. Mm-hmm. ERC, let, let's talk about the difference between refundable credit and a non-refundable credit.

Mike: Most tax credits are non-refundable, meaning they can only reduce your tax by what you would otherwise pay. There are some, like the earned income credit that will actually, even if you haven't paid any taxes, the government will give you some money back. Um, those are fundable credits on those credits.

Mike: The IRS has found over and [00:21:00] over and over again. People cheating on it, so they're gonna go, I mean that's, like Kevin said, the IRS agents aren't generally the hardest workers in the world. They're gonna go find the lowest hanging fruit. Um, and if you're filing for these, you're filing a red flag. 

Kevin: Yeah. Yeah.

Kevin: It's, it's, it's sad to see they go after the, those, those, uh, lower income individuals. 'cause they can't afford the representation. They can't, they, they just see the IRS and they ah, and they panic and they'll just pay it. Or maybe they can't pay it and they have to get on installment. Um, it's very unfair and it's not worth the time.

Kevin: I mean, one of a big audit. Red flag, honestly. And something that you're in zero control of is your income. Mm. If you are making a million, 5 million, 10 million. You're red flagged, sorry. If you're making substantial money, the time the I the auditor can spend on a $10 million taxpayer, they can almost spend the same time, if not just a little bit more time than on a [00:22:00]hundred thousand dollars taxpayer.

Kevin: Think of the ROI of a mistake on a $10 million taxpayer versus a hundred thousand. It's a huge difference. So your audit risks are gonna go up, the wealthier you become, but also going along with. Kind of your wealth generation is probably your team. You're gonna have a CPA, you're gonna have financial advisors, attorneys.

Kevin: So audit risks are gonna go up, but so is your team. Your, your, your, your bench is gonna get deeper, smarter, and you're gonna be better protected even though you might have more audit risk. But that's just one audit, red flag you can't get rid of. Um, and you don't want to get rid of, mean. The whole goal is wealth generation, and if you're doing your job, you're gonna increase your audit risk.

Kevin: But part of our job is to come up with. Strategies to get you into lower tax brackets to where maybe you are making 5 million bucks, but we can get you a million under taxable. Maybe that that's gonna do a couple things. One, you're saving your a heck of a lot in taxes, but also you're gonna be reducing your audit risk just from that net worth calculation.

Kevin: But you might be [00:23:00] increasing your audit risk. 'cause we're lopping off $4 million of income. 

Mike: So give and take. Yeah, I mean it, it is a give and take. It's sad the more successful you are. Um. The more likely you're gonna have to deal with the IRS. But again, look at it from the positive side of things. The more money you make, that's means your potential tax burden is increasing.

Mike: With our income tax system, that's just how it works. The more potential income tax you have to pay. The more tax benefits or potential tax strategies are available to you out there to reduce your taxes. So I hear this over and over again. We're gonna do another, um, podcast on top, miss we hear about taxes and, and one of 'em is, uh, just to give you a, a prelude, just because you're making more money doesn't mean you have to make, pay more taxes.

Mike: Um, you just gotta find a better strategist and honestly spend some more time focusing on 

Kevin: it. You hear it all the time, but. Rich people. 

Mike: I hate that 

Kevin: Trump makes $10 million and he pays [00:24:00] 15% 

Mike: and 

Kevin: yeah, 

Mike: he's 

Kevin: following the law. He's using the laws that he didn't even make. Nope. These laws have been around way before his tenure.

Kevin: Yep. He's just utilizing wisely. The same thing we do with our clients, just not on Trump's billion dollar level. I want a billion dollar client one day. That'd be fun, but maybe not. Yeah, not necessarily. So they're just using the tax code to their advantage. That's all they're doing. 

Mike: That's a big portion and reason why we have this podcast, why we care so much about educating people out there is the truth is the wealthiest people out there, they take all the tax benefits they can find.

Mike: They have teams of lawyers, teams of CPAs helping to educate them and helping them to. Utilize the tax law for their benefit. Why should it just be for the richest? You get those same tax benefits if you make 500,000 that someone making 10 billion a year can get, you get all the same benefits. As a matter of fact, in a lot of their cases, the really wealthy, they have gone to tax [00:25:00]court and.

Mike: Fought the IRS and won. So we have these wonderful, and they paid a lot of money to do that, but they saved a lot in taxes. But we have this wonderful trail of tax law and tax court precedents that we can learn, teach you say, Hey, you don't need to go pay a hundred million dollars to tax attorneys come up with this.

Mike: This has tried and true and this has been with upheld as legitimate in a tax court. You can utilize it too. 

Kevin: Yeah. So. To summarize kind of everything. Don't use round numbers, don't cheat, make, make a lot of money. Do your tax planning. Red flags are out there. Don't be scared of them. Just prepare for 'em. It, it's, it's something that's, and it's not inevitable for you to be audited, but we don't need to in incre, we don't need a spotlight on you.

Kevin: No. There's ways to cr to get the spotlight off of you and. Still be aggressive and still tax plan, uh, all within the legal limits that you're allowed to, um, it's playground out there. 

Mike: I wanna close with one final big red flag. If you don't file your [00:26:00]tax return and you've made money, that is a huge, what do you hide it?

Mike: Huge red flag. What are you hiding? And the worst part about it is, is if you don't file that tax return, there's no statute of limitations as begun. I could come from you 20 years from now and get you on that because you didn't file your tax return. And like Kevin said, you don't file. They know you're hiding something.

Mike: Remember, you might think, Hey, I'm getting paid cash. I don't have to file. I promise you in this day and age. In this digital world we live in, the IRS is gonna figure out, you made some money somewhere. You might just be advertising on Facebook. Well, guess what? They got teams of people at the IRS checking Facebook and cross-checking with these people, filing, file your tax return.

Mike: Don't cheat the tax code. 

Kevin: Leverage it. Use it. 

Mike: Absolute. Absolutely. 

Kevin: And if you get paid cash, the odds of you getting getting caught are low. But here's how you get caught. Let's say you get paid three, 10, $15,000 in cash from earned income. You don't report it. [00:27:00] There's no 10 99. Oh, how are they gonna know you get audited?

Kevin: That's how they know because one thing they, they request on your tax, on your audit is bank statements. And they're gonna be like, Mr. John Smith, what's this $15,000 deposit going in your bank on March 3rd? Um. Uh uh Oh. So then you gotta either lie, which is lie to a federal, that's not gonna go well, no.

Mike: You're gonna prison if you die. Don't do that. 

Kevin: Yep. So then now you're, but now you're, the best thing you can do is come clean and be like, oh, that's right. I forgot I did this job. Or I don't know. 

Mike: And it's not only you that have to be audited, maybe the guy that paid you $14,000 cash gets audited. And in that audit they decide to see, well, did he really pay you 14,000?

Mike: So then they might even subpoena your bank records without you knowing and see if it went in there. Um, or they might decide to open up an audit. Uh, so just be careful. Don't cheat the tax law. There's no need to. There's so much benefit and incentives in there for you to legally pay a lot less in taxes than you're probably paying today.

Mike: And that's what [00:28:00] I'm gonna close with.

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