Good news! The chance you’ll need an IRS tax attorney because you’re being audited isn’t that great. You have about the same chance of dying in a motor vehicle accident (1:100). Last year the IRS audited 1.1% of the more than 142 million returns filed the year before, but for taxpayers making less than $200,000, the rate dropped a bit to about 1.0%.
However, if you’re in a higher income category, you have more reason to worry, even if you keep a tax attorney on retainer. It seems a higher income is an automatic audit trigger. The tax audit rate of those with incomes higher than $200,000 was 2.7%, and for those earning more than $1 million, the audit rate jumped to 8.4%. Why? Finding a 15% mistake on someone making $40,000/yr has a much different payout than someone making $4,000,000/yr.
Many IRS audits are relatively simple “correspondence” audits. It’s that letter in a plain envelope that you dread and yes, I’ve gotten them – actually I’ve gotten several. Several years ago I was a part owner of a very successful lumberyard and we were on the IRS watch list I guess. No one likes to get a letter from the IRS, but it’s probably less nerve wracking than a tax agent knocking on your door. I’ve been through that too … on a Sunday morning with 3 agents in dark suits and sunglasses knocking on the door at 6:00AM. Not fun. More than 1 million of the almost 1.4 million audits last year were correspondence audits, while about 310,000 were field audits.
Chances of being audited
Source: IRS and BusinessWeek
How a return is selected for an audit
Just like your credit score, you also have an IRS “score,” called the Discriminate Function Score (DIF). Based on a sample set of thousands of returns, the IRS determines what an average range and a valid range for, say, the amount of charitable contribution deductions claimed by a person earning $50,000/yr. Then, a taxpayer making that income level who claims a much higher deduction will get a higher DIF Score, and that taxpayer’s audit probability goes up.
That system only finds discrepancies with deductions; it doesn’t (can’t? … yet?) find someone who is under-reporting income. So, the IRS also examines certain types of businesses … especially cash businesses.
The IRS estimates that up to 15 percent of the $1.9 trillion reported each year (that’s $290 billion+) goes unreported. As a result, in addition to high DIF scores, the tax agency focuses on cash businesses, such as restaurants, gas stations, house painters, flea market peddlers, domestic housekeepers, and hair salons. If the business primarily accepts cash as payment, it’s probably in the IRS’s crosshairs.
For small-business owners who receive a 1099, this is less of an issue, as the IRS can check what the taxpayer reports against the 1099 filed by the business that paid the money. In that situation, the IRS has a record of all your income.
Never be afraid to take a legitimate deduction
If you have a legitimate deduction and the paperwork to support it, take it. Don’t be intimidated into letting a deduction go by the wayside just because you fear an audit.
Your best bet is to always be honest and truthful when completing your tax return … even if what you’re reporting is outside of the norm.