It is no secret that one of the biggest fears people have is receiving an audit notice from the IRS. This fear ranks right up with being diagnosed with a life threatening illness on most taxpayers’ lists. Of course, the IRS does nothing to alleviate this fear. They reason the more fearful you are, the less likely you would be to cheat on your taxes.
The Internal Revenue Service audited almost 1.6 million individual taxpayers in 2010. That’s an 11 percent increase over the year before and more than double the agency’s pace just eight years earlier. The U.S. Government is facing another trillion-dollar budget deficit this year making it even more important to collect every dollar it’s owed under the tax code.
Not everyone stands the same chance of being audited. According to the IRS website, they select returns for examination in five ways:
- Computer scoring by DIF (discriminate information function), a formula used to select returns for review
- National Research Project
- Local and national projects that look at particular areas
- Information matching, such as Forms 1099
- Related returns
Some of these methods are entirely at random. If your return is pulled, it is just the luck (bad luck) of the draw. However, the DIF system is not a random selection process. Based on a closely guarded formula, the DIF system analyzes tax returns for oddities and discrepancies. The DIF system scores returns and those with the highest DIF score are examined by experienced IRS agents to determine if an audit is warranted.
Here are some of the items the IRS thinks require closer scrutiny:
1. Large Itemized Deductions
The IRS has established ranges for the amount of itemized deductions based on a taxpayer’s income. Deductions that exceed the statistical “norm” for a given state and region may be red-flagged for a closer look. This does not mean that you shouldn’t take legitimate deductions. High medical expenses and large charitable contributions are reasons your amount of deductions could be higher than the IRS range. You should take all valid tax deductions. Just be sure you keep all your backup documentation.
2. Self Employment Income
The IRS believes that the vast amount of underreported income occurs among the self employed. Self employed taxpayers are audited by the IRS far more frequently than employees that receive a W‑2 for wages. People that are employed by others and receive W‑2 income and also run a business that reports a loss are especially high on the IRS radar screen. You will need to be able to prove you are operating a business with the intention of earning a profit and not just trying to write off the expenses of a hobby. You will need to be able to pass both the “passive loss” and “hobby loss” rules in order for the deductions to stick.
3. Missing Investment Income
Financial services companies are required to report all interest & dividends on tax form 1099. Now they are also required to report realized gains and losses on the tax form 1099‑B. The IRS gets a copy of the same form 1099 and runs a computer match to verify that you are reporting the same amounts. Make sure your tax return matches the numbers provided.
4. Other Unreported Income
The IRS has many reporting sources that are matched with your return to be sure all income is reported. In addition to the 1099 reporting of dividends & interest, wages are reported on form W‑2. Pensions, Social Security income, tax refunds and self-employment income are all reported. The best way to guarantee an IRS query is to forget to report income. If your return is missing a few pieces, the IRS may wonder what else you forgot.
5. Home Offices
Taxpayers that operate a business from their home are entitled to deduct the portion of their home that is dedicated to operating the business. The IRS believes that many taxpayers use this deduction as a means of writing off personal expenses and carefully scrutinize tax returns that claim the home office deduction. Claiming this deduction greatly increases the chances that your tax return will be audited. You should consult a tax expert to determine if you are entitled to claim this deduction. If the tax savings are minimal you may opt not to claim the deduction simply to avoid the scrutiny. For details, see IRS Publication 587.
6. Round numbers
Round numbers do not happen very often in the real world. Capital gains are rarely exactly $1,000. Round numbers are an indication that you are estimating rather than keeping good records. If your mortgage interest is $983 don’t round it off to $1,000. Report the exact amount.
7. Matching State & Federal Returns
Most states are now sharing information with the federal government. Make sure the information you report to the state is the same as what you put on your federal tax return.
8. Mathematical errors
Double check your return before filing to make sure all your numbers add up properly. A math error on your return will cause it to be flagged and someone will have to check it to determine what caused the error.
There is no way to completely audit proof your return. Some returns which are selected for audit are done completely at random. If you do get an audit notice from the IRS don’t take it personally. It does not mean the IRS believes your return is fraudulent. A good place to start when you get an audit notice is to pick up a copy of IRS Publication 1 “Your Rights as a Taxpayer”. You want to be courteous and helpful without volunteering more information than what the IRS is requesting. Plan ahead so that you are organized and can answer questions promptly. Ask for a postponement if you need more time to prepare.
The common thread running through the high risk returns are those taxpayers that are self-employed or have unusual circumstances that place the return outside of the statistical norm. If this describes your return, let a professional prepare the return. Self- prepared returns are themselves more likely to be audited. The IRS believes that a non- professional has limited knowledge of the 4,000 pages of existing tax code. Tax law is complex. The fee charged by an Enrolled Agent or CPA can be easily justified by the peace of mind they bring if you get the dreaded audit notice.
- When preparing your own tax return, use tax preparation software to help cut the risk of an audit and avoid math errors.
- The home office deduction can cause more problems than it is worth. Be sure to review IRS Publication 587 to assure you are doing this properly.
- Don’t hesitate to appeal an IRS order if you disagree with the auditor’s findings. Send a
protest letter to the IRS Office of Appeals within 30 days of receiving the report.