With tax season in full swing, the fear of receiving an audit notice from the Internal Revenue Service escalates. By avoiding high-risk areas and meticulously checking all the information on your tax return, your fears can be alleviated, but not eliminated.
Bob stopped in my office one day last summer for his quarterly financial review. I had planned to give him a quick update on his investment strategy and then spend the rest of the time going over some end-of-year tax planning. Unfortunately, Bob arrived without his 2008 tax return, which contained some information I needed. His explanation was that the return had not been filed yet. He never files before the October 15th extension deadline because the theory is the IRS doesn’t audit returns on extension. He didn’t want his tax return to be selected for audit.
Imagine his surprise when he received an audit notice later that year.
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 the diagnosis of a life-threatening illness on most taxpayers’ lists. Of course, the IRS does nothing to alleviate this fear. They reason that the more fearful you are, the less likely you will be to cheat on your taxes.
The chance of being audited is actually quite remote for most people and not everyone stands the same chance of being audited. According to the IRS website, based on 2007 audited tax returns, it selects 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 of the return;
- Information matching, such as Forms 1099; and
- Related returns.
Some of these methods are entirely random. If your return is pulled, it is just the (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 scores are examined by experienced IRS agents to determine if audits are warranted.
Some areas of your tax return are more likely to cause an audit:
- 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 back-up documentation.
- 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 who receive W2s for wages. People who are employed by others and receive W2 income, and also run businesses that report losses, 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.
- Automobile Expenses – The IRS commonly audits individuals who use their own cars for business purposes. It is very important that you keep good records of expenses and mileage. It’s recommended that you maintain a log to show business-related mileage or, at a minimum, write down the beginning and ending odometer readings in your appointment book.
- Home-Office Deduction – A taxpayer who operates a business from his/her home is entitled to deduct the portion of the 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 scrutinizes 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 not want to claim the deduction in order to avoid the scrutiny.
Staying Off the IRS’s Radar Screen
Though you may not fall under any of these high-risk areas, your tax return may still come to the attention of the IRS. Here are a few more ways to avoid drawing attention to your return:
- Unreported Income – The IRS has many reporting sources that are matched with your return in an effort to be sure all income is being reported. Interest and dividends are reported on Form 1099. Wages are reported on Form W2. Pensions, Social Security income, tax refunds and self-employment income are all reported, as well. The best way to guarantee an IRS query is to forget to report income.
- 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.
- 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.
- 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.
The common thread that seems to be running through the high-risk returns involves those taxpayers who are self-employed or have unusual circumstances that place the returns outside of the statistical norm. If this describes your return, let a professional prepare it. Self-prepared returns themselves are more likely to be audited. The IRS believes that a non-professional has limited knowledge of the 14,000 pages of existing tax code. Tax law is complex. The fees charged by enrolled agents or CPAs can easily be justified by the peace of mind they bring if you get the dreaded audit notice.