Few things in life are more scary than a tax audit. If you’re like me, even if you’re relatively sure you did nothing wrong, when you get one of those envelopes in the mail your stomach tightens, and you feel just a little light headed. The key is to do whatever it takes to make sure you have everything in order regarding your taxes, that you maintain good records of income, expenses, and deductions, and that you have been accurate in your calculations. But what causes some returns to be audited and others to be accepted without question?
Criteria for IRS tax audits
1. You just didn’t pass the computer’s “smell” test.
Your return may be selected for what the Internal Revenue Service calls “an additional examination” on the basis of computer scoring. A computer program called the Discriminant Inventory Function System (DIF) assigns a numeric score to each individual and select corporate tax returns after they have been processed. Drastic changes in income is one way to increase your DIF score and trigger an audit because, the way the IRS looks at it, you may have under-reported your income LAST year. If your return is selected because of a high score under the DIF system, the potential is high that an audit of your return will result in a change to your income tax liability. In general, the IRS will audit returns that have a high potential for a return on the examiner’s time!
2. You made how much last year?
Your return may also be selected for “additional examination” on the basis of information received from third-party documents (think 1099′s and W-2′s). If these numbers don’t match the numbers you reported on your tax return, the IRS will question what you did, what you reported, and why. Your reported income should match the lifestyle you live. Living like a pauper but reporting income like a king is okay, but living like a king and reporting income like a pauper is a quick ticket to the audit office.
3. Your nasty neighbors can turn you in!
In addition, your return may be selected as a result of information received from other sources on potential non-compliance with the tax laws or inaccurate filing. This information can come from a number of sources, including newspapers, public records, and individuals. Although the information is evaluated for reliability and accuracy before it is used as the basis of an examination or investigation, keep that in mind if you’re given to bragging about how much you scored in Atlantic City over the weekend. I’ve also heard of people turning in those who boast about cheating the IRS.
Which tax returns are more likely to get audited?
The IRS does look at certain characteristics of individual returns where taxpayer:
- Claimed the Earned Income Credit
- Returns with Schedule C (business profits and losses)
- Returns with Schedule E (supplemental income or loss)
- Form 2106 (used to report employee business expenses)
These items are more likely to be examined by the IRS. Don’t be afraid to file the proper schedules and forms if you have legitimate expenses and you are legally allowed to take them, but DO be aware that these are more closely scrutinized.
What steps should you take to avoid a tax audit?
Accuracy, accuracy, accuracy. An inaccurate return has a much higher chance for “additional examination.” So always insure the accuracy of your return. I have personally used H&R Block Online’s tax preparation software for well over a decade. I’ve found it to be easy to use, reliable, and able to handle any tax problem I’ve thrown at it over the last 15 years. There have been several years where my return was extremely complicated and H&R Block Online worked like a charm!
Next, make certain you report ALL your income, W-2 income, income from rental property, and any 1099-MISC non-employee income. If there is any income associated with your Social Security number, you better report it! Also, be sure to include any tips or cash payments you received for work or sales as well as the value of any services you barter. And don’t forget any hobby income, too. Under-reporting your income just because there are no official documents can come back to bite you.
Finally, make sure your deductions are in order by keeping detailed and accurate records. If you have some unusual deductions (either in type or amount), get photographs to substantiate them. If you have some unusually high repair costs to your rental property because of tenant damages, photographs will help your case in the event of an audit to your taxes.
If you deduct the expenses of an independent contractor (lawn services for your business, SEO work for your blog), you must issue a 1099 unless the payment was less than $600.
If you’re deducting non-reimbursed employee expenses, use whatever method is conventional in your industry. The IRS is flexible on these deductions so long as your method of calculating them is consistent with others in the industry. Some industries deduct mileage, for example, while others deduct actual expenses associated with travel. Whichever method you choose, be consistent.
A tax audit isn’t the end of the world and if you get a notice that you’re being called into the local office, or an examiner plans to visit your home or business, or you’re simply supposed to respond by mail, give the IRS the information it requests without reservation. Some audits are random, but most are the result of statistical comparisons to the norm. Even though large deductions can trigger an audit, you DO have the right to take all legitimate deductions and the right to appeal any decision the examiner makes if you don’t agree with it.