Receiving a tax refund is often a moment of relief, but that relief can quickly turn into anxiety if a letter from the IRS arrives shortly after. These notices frequently signal that the agency has identified an error in your filing—errors that can lead to delayed payments, reduced refunds, or even financial penalties.
To help taxpayers navigate these complexities, Katrina Martin, an enrolled agent and founder of Wow Tax and Advisory Service, identifies the three most frequent mistakes that trigger IRS scrutiny.
1. Mismanaging the Earned Income Tax Credit (EITC)
The Earned Income Tax Credit is a significant benefit designed to support low- and moderate-income individuals and families. Because it is a refundable credit —meaning it can result in a payment even if you owe no taxes—the IRS monitors it with extreme rigor.
According to industry data, a substantial portion of EITC claims are flagged for improper payments. Most errors in this category stem from mistakes regarding qualifying dependents. Common issues include:
- Dependency Errors: Claiming a child who does not meet specific age, residency, or relationship requirements.
- Duplicate Claims: Multiple taxpayers attempting to claim the same child.
- Data Mismatches: Discrepancies between the name or Social Security number on the tax return and the official records.
- Income Discrepancies: Reporting incorrect income levels that disqualify the taxpayer from the credit.
2. Incomplete Income Reporting
A very common reason for receiving an IRS notice is the failure to report all sources of income. This often occurs due to timing issues : taxpayers frequently file their returns as soon as they receive their primary W-2, before all other documents have arrived.
It is vital to remember that for every tax form you receive (such as a W-2 or a 1099), a copy is sent to the IRS. The agency uses automated systems to match the information on your return with the forms in their database.
Pro-tip: To avoid “recalculated” returns and subsequent letters, wait until you have received every single tax document before submitting your filing.
3. The “Hobby vs. Business” Dilemma
For entrepreneurs and freelancers, claiming consistent business losses can be a major red flag. The IRS distinguishes between a legitimate business—run with the intent to make a profit—and a hobby, which is essentially a personal activity.
If a business consistently reports expenses and losses without generating revenue, the IRS may question its legitimacy. To mitigate this risk, tax professionals point to the “3 out of 5 rule.”
The 3 out of 5 Rule
To demonstrate a legitimate profit motive, a business should ideally show a profit in at least three of the last five years. If your activity fails this test, the IRS may reclassify your business as a hobby, which can disqualify you from certain business-related deductions.
Summary
Most IRS letters regarding refunds are triggered by errors in dependency claims, incomplete income reporting, or inconsistent business profitability. By ensuring all documentation is present and qualifying criteria are strictly met, taxpayers can significantly reduce their risk of an audit or penalty.
