How to Avoid an IRS Tax Audit

This is the second post in a three-part series we’re calling Tax Boot Camp—because Uncle Sam wants you, but he also wants your money!

What Is an IRS Tax Audit?

You’re probably familiar with the term tax audit. That’s when the IRS picks you as one of the lucky ducks to check up on. The IRS calls it an “examination” and they can review an individual’s or an organization’s financial information to make sure that what’s reported on a tax return is in line with the law. In this article you’ll learn how the IRS selects tax returns to audit, ways to avoid being chosen for an audit, and what to do if the IRS picks you out from the crowd.

How the IRS Selects Tax Returns to Audit

In recent years, less than 2% of all income tax returns have been audited. But the audits done in 2009 alone brought the IRS close to $50 billion dollars in additional tax revenue. Though the IRS doesn’t reveal their super-secret-audit-selection formula, there are some things that make you more likely to get audited—so we’ll review those red flags.

The IRS computer program assigns each tax return a score, and the higher the score, the more likely you are to have underpaid taxes and therefore to be chosen for an audit. You could also be selected for examination when the tax return of someone close to you, like a business partner, is audited. Or if a whistleblower, like an angry ex-spouse or an employee, turns you in. Tax returns can also be selected at random, so you can be chosen for no reason other than pure statistics.

How to Avoid an IRS Tax Audit

So let’s focus on some of the issues that can increase your chances of being audited. You might not be able to do anything about them, but you can take extra care not to shine a light on your return by making any unnecessary errors.

Tax Audit Red Flag #1: Unreported Income

Since taxes are calculated on how much money you make, not reporting all your income from various sources is a big mistake that’s sure to result in further scrutiny. Don’t forget that you may have income from bank accounts, the sale of investments or real estate, and alimony, for instance. If you innocently forget to report even a small amount of taxable income, the IRS will find out when they match records submitted by the people and companies that paid you.

The IRS receives duplicate copies of all the forms you receive and eyebrows are raised when information on your tax return doesn’t match up to a Form W-2 or a Form 1099, for instance.  If you didn’t receive a tax form for some of your income, don’t assume that the IRS won’t know about it—be sure to contact the payer and request a copy of the tax form so you can submit it along with your return.

Tax Audit Red Flag #2: Cash Income

The IRS knows that businesses and people who get paid in cash are more likely to under report their income. If you make money that isn’t reported on a Form W-2, that could trigger an audit. So be careful to report cash tips if you’re a restaurant server, a taxicab driver, or a bartender, for instance.

Tax Audit Red Flag #3: High Income

As your income goes up, so does the likelihood that you’ll be audited. If you make more than a million dollars, your chances of being audited are over six times higher than if you make less than $200,000.

Tax Audit Red Flag #4: High Deductions

In the first episode of Tax Boot Camp, I covered tax deductions and tax credits. If your itemized deductions exceed certain thresholds for your income—for example, you claim a really big charitable donation that’s a significant percentage of your pay—then you could be singled out for an audit. That doesn’t mean that you shouldn’t claim every deduction that you’re entitled to—it simply means that you need to have good records to back up what’s on your tax return.

Tax Audit Red Flag #5: Self-Employment

If you own a business or work for yourself, there are lots of expenses you can deduct, like work-related entertainment, travel, and equipment. Because the line between business and personal use can be crossed so easily, self-employed taxpayers are targeted more frequently for an audit.

Tax Audit Red Flag #6: Home Office Deductions

The tax rules for deducting home office expenses can be complicated, and that’s why the IRS tends to audit taxpayers who work from home. If you’re a website designer with a home office who earns $40,000, it would look strange for you to take $30,000 in deductions. Be sure that you don’t try to deduct items that aren’t used for business. If you do have a lot of deductions, make sure you have documentation to prove that they’re a valid part of your job or business.

Tax Audit Red Flag #7: Automobile Deductions

Another deduction that’s commonly audited by the IRS is vehicle use for your job or business. It’s really important to keep good records of all your transportation expenses and a mileage log that clearly shows how many business miles you’ve driven during the year.

Tax Audit Red Flag #8: Complex Transactions

If you claim complex or unusual expenses on your return, it’s wise to provide an explanation before the IRS has to ring you up and ask for one. Submit a note with your return explaining why you have an unusual situation or are missing a particular tax form, for instance.

Should You Use a Tax Accountant?

Whenever you have a fairly complicated tax situation—like owning rental property, being a business owner, or having a home office—it’s a good idea to let a tax accountant do your return. They’ll make sure everything is legitimate and that you have the right paperwork to back up your claims. But remember that as the taxpayer, you’re the one who’s legally responsible for what’s submitted to the IRS, so choose your tax preparer carefully.

What Should You Do If You’re Audited?

If you do receive a notice from the IRS asking for additional documentation or informing you that you’ve been selected for an audit, respond right away. It doesn’t mean you’ve done anything wrong—the IRS may just need clarification from you. However, if you’re worried, you may want to be represented by a CPA who specializes in taxes or by a tax attorney, to make sure you come out on top—or at least that you end up owing the IRS as little as possible.

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More Resources:
Guide to an IRS Small Business Audit VIDEO
IRS Tips for Choosing a Tax Preparer
The IRS Examination (Audit) Process

IRS Audit image courtesy of Shutterstock