Well, here we go again, these days everyone is talking about audits. I normally try not to join into what everyone is doing but, Some things need to be Pointed out.
First and foremost, there is no sure fire formula or guide that dictates by “doing this you’ll avoid an audit.” At best you can do is lower the possibility and having the records to substantiate your return. Meaning, have the records to back up the numbers.
The IRS conducts random audits to serve as benchmarks for its examinations. The best things you can do are file on time and pay what you owe. When it comes down to it, punctuality and accuracy are the only things the IRS really wants.
Yet for those returns that aren’t pick randomly, there is a system of IRS software called the Discriminant Inventory Function System that analyzes tax returns for oddities and discrepancies. This secret software the IRS uses, is based on a closely guarded formula. Basically the system assigns each return a score that determines whether or not the IRS will audit you.
Here are some common “red flags“:
- significant income increase or decrease
- significant deduction-to-income ratio — say, $40,000 in deductions on a $50,000 income
- business deductions consisting of fancy dinners and pricy trips to the Moulin Rouge
- home-office deductions
- low tip income for workers who traditionally make a lot of money from tips
- income exceeding significant benchmarks, such as $100,000 and $1,000,000
- self-employment
- computational mistakes and typos
- incorrect Social Security number
- incorrect reporting of income, deductions, and the like.
- late filing without applying for an extension with Form 4868
- not paying your full tax liability without applying for an installment agreement with Form 9465
Obviously, you can’t avoid an income change if you get a better-paying job. If you’re self-employed, you’re self-employed you’re not going to change that. However, you can still do some things to decrease the likelihood you will be targeted for examination:
- Keep Good Records – in the grand scheme of things, this is easy
- Explain Yourself – include the receipts, a written explanation and any other appropriate documentation with your return
- Don’t go overboard with your deductions – especially if you’re self-employed. Also, don’t estimate your deductions — use exact amounts based on receipts.
- Beware of Tax Software - Tax software is great for returns at the simpler end of the range. But, when you start getting into deductions and complex sources of income, it is best to verify the accuracy of your return with a tax professional.
- A sloppy return is sure to get a thorough check by the IRS, especially if the all-important numbers are illegible.
- Check and Recheck Your Return – no errors in your math, make absolutely sure all your math is correct.
You might also lessen the chance for an audit by having it prepared by a professional. I have heard from local IRS auditors that say they are more likely to pick a self-prepared return then one prepared by a reputable tax pro.
The best way to handle an audit is to simply stay prepared for one. You should keep a record for every line item on a tax return.
The government (IRS) isn’t kidding. It wants its revenue, and if you can’t justify a tax break, it’s not likely that you’re going to be able to keep it.
© 2009, Bruce Mc. All rights reserved.
Bruce-
Great post – welcome back!
I just want to add something to your mention of “significant deduction to income ratio” as a cause for an increased DIF score and audit possibility. I do believe that the IRS program has identified significant “deduction to income ratios” for each item of deduction – medical, taxes, interest, contributions, casualty and theft loss, and miscellaneous, etc.
It is indeed very important to, as you point out, “Check and Recheck Your Return”. This is especially true of tax returns generated by tax software. Way too often individuals, and tax preparers also, assume that a computer generated return is mathematically correct, and that all totals are carried forward to the appropriate line properly, and therefore do not check and recheck the accuracy of the return. This is a huge mistake – every single tax return, whether prepared manually or generated by a software package, should be checked and rechecked in the same manner.
And not for the question that I have been posing fellow tax preparers – Would you ever advise a client to omit a legitimate and documented deduction from their 1040 simply because it may slightly increase the chance of an IRS audit?
Thanks!
TWTP
TWTP,
As to your question, I encourage clients to use all that is available. It is the questionable documented deductions I suggest they omit or “hold back” in the offhand change we need it latter. Haven’t needed one yet.