It is once again that joyous time of year when spring returns, the flowers start to bloom, and your CPA is filling your inbox with pleas for your tax information so that he can at least extend your income tax returns. As you gather your data to hand over, there are usually two thoughts that go through every taxpayer’s head: I hope I don’t owe any taxes and I hope I never get audited about this.
This article cannot help you with your first concern about owing taxes, but it may shed some light on your second worry. First, the good news. The IRS doesn’t have enough staff to audit the vast majority of returns filed each year. In fact, it audits only slightly more than 1% of all individual returns. In 2010, 8.4% of individuals earning over $1 million were audited and only 2.7% of individuals making over $200,000 (but under $1 million) were audited. In some respects, getting audited is like losing the lottery.
But let’s say you have the misfortune of getting a notice from the IRS. What does it mean?
Some letters are straightforward Correspondence audits, which happen when the IRS sends
a letter asking for clarification on relatively simple items. It’s usually handled and completed
through the mail. Common issues are: (1) the income reported on your tax return is less than
the Forms W-2 or 1099 filed by your employers/clients; (2) the reported proceeds on your
Capital Gain Schedule (Schedule D of your tax return) is less than the Form 1099-B filed by
your broker, and; (3) your reported tax payments don’t tie with what the IRS has on record. The
IRS computers automatically generated the letters because the information the IRS got from
you does not agree with the information the IRS got from a third party. These are usually simple
problems to resolve. However, don’t ignore them – they will not magically go away!
Other IRS letters may require more work, and may be notice of a Field audit, where an agent
will want to examine your books in person. These types of audits are more in depth and
generally have a greater potential to result in interest and penalties than the Correspondence
audit. Even if you receive a no change letter, indicating the IRS did not find an irregularities,
Field audits typically cost you money because you hired a professional to help handle the audit.
Therefore, the best advice is to try to avoid the Field audit. There are some obvious no-no’s
that shift your return to the audit pile. The following measures won’t guarantee you’ll avoid an
audit, but they’re key issues that the IRS focuses on when deciding which returns to target:
Messing up the basics: This is an obvious point, but remember to sign the return, add the Social
Security Number, and double-check the math. Fill out every applicable line on the return or
get a tax preparer to do it since professionally prepared returns tend to be easier to read and
understand. Tax preparation software has made this problem less likely, but the bottom line is
that sloppy returns tend to draw scrutiny.
Rounding can be a problem: Precise numbers suggest precision. It’s always best to show
conservatism to the IRS. Don’t round up those expenses to the nearest thousand.
Note sales of investments carefully: Anytime you sell stocks or bonds, the IRS and the taxpayer
receives a 1099 noting the sale price. Your tax professional can go over the proper way these
should be noted on your return. Also remember that income items such as interest, dividends
and other sources of income are matched with the return from documents that are already on file with the IRS.
Scores are everywhere: In case you didn’t know, the IRS – like the lending industry – assigns
you a score. It’s called the Discriminate Information Function (DIF), a computer program that
compares, among other things, the deductions you’re taking against others in your income
bracket. It’s the way an increasingly technology-driven IRS is screening for suspicious returns.
One of the best ways to avoid a high DIF score is to report all income – don’t let yourself think
that any amount is not worth reporting.
Be wise about itemized deductions: You should claim every deduction the law entitles you to,
but a good tax professional can advise you of reasonable limits that are less likely to trip your
return. In particular, the IRS looks for overblown charitable deductions – make sure you make
cash contributions by check or credit card so there’s a record, and just make sure that all your
donations have receipts or other acknowledgement from the charity – that’s a strict requirement
of the Pension Protection Act of 2006.
If you do get audited, you need to prove the original value of the items donated and their fair
Keep scrupulous mileage records: If you use your vehicle for work or business, keep a notebook
or chart in the car so you can record mileage information as soon as you complete it. The
records should list beginning and ending odometer figures, location and reason for the trip.
Keep the same records for mileage claimed for medical expense and charitable purposes.
Watch that home office: Even though the government loosened restrictions on home office
deductions in 1999, make sure you can substantiate that business area of your home if you’re
asked. Remember that the home office must be used exclusively for business. Don’t have it
double as a playroom or gym.
Running personal expenses through your business: For tax purposes, an expense is deductible
against your business income only if it is an ordinary and necessary expense. Buying a hot
tub for your home and charging it to your business doesn’t qualify. Be careful about using your
business to purchase personal items. That will be extremely difficult to defend at audit time and
will invite further scrutiny.
In conclusion, the odds of getting audited are low, but you can reduce your chances even more
by exercising some good judgement.