Top 10 Ways To Avoid a Tax Audit

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"Worried
about an IRS audit? Avoid what’s called a red flag. That’s something
the IRS always looks for. For example, say you have some money left
in your bank account after paying taxes. That’s a red flag."

~ Jay
Leno

While Leno
might not have it exactly right, he is on to something: The IRS
does look for red flags when selecting a return for audit. Their
methodology, however, is a little more sophisticated than what the
comedian suggests. While there’s no foolproof way to escape an audit,
here are some tips for keeping your return from being flagged:

1. Be good
at math.
The IRS continually cites
bad math as one of the top errors on tax returns
. Making math
mistakes on your tax return will get you noticed – and not
in a good way. While the IRS will generally just correct your mistake
and send you a bill, too many math errors might indicate a level
of carelessness that causes your return to be flagged. So, use caution
when preparing your return. Copy numbers onto forms or input into
software carefully – and double check those numbers when you’re
done. Check for transposition errors, as well as addition and subtraction.
Don’t have a false sense of security when using a software package.
Your tax prep software can’t tell when you’ve made a mistake before
entering your data.

2. Don’t
be too rich.
Statistically, you’re about six times more likely
to be audited if you report over $1 million in income than if you
report income of less than $200,000. You’re
about three times more likely to be audited
if you report between
$200,000 and $1,000,000 than if you report income of less than $200,000.

Does the IRS
have it out for the rich? Not necessarily. Those who make more money
tend to take advantage of more itemized deductions, such as charitable
contributions, which attract the attention of the IRS. Filing a
Schedule A with significant charitable contributions or miscellaneous
expenses may trigger an examination.

It’s also highly
likely that many higher income taxpayers are small business owners.
Statistically, taxpayers who file a Schedule C are two to four times
more likely to be audited. Many tax professionals recommend that
taxpayers who are collecting substantial income from a small business
consider incorporating in order to avoid filing a Schedule C that
attracts attention.

3. Don’t
be too poor.
While the upper class is generally the target of
most audits, the other end of the spectrum isn’t spared. When examining
returns, the IRS is particularly interested in errors related to
the Earned Income Tax Credit (EITC), a refundable credit that may
only be claimed by lower income taxpayers. In 1999, the IRS reported
$8.5 billion and $9.9 billion in over-payments related to the EITC.
The
error rate is about 30%
, nearly three times higher than with
other social programs.

Despite initiatives
put in place to stamp out EITC errors and fraud, as recently as
2002, the IRS reported that it had issued
math error notices on more than 1 million returns claiming $729
million in EITC
. Common mistakes included amounts that were
figured or entered incorrectly; missing or incorrect taxpayer ID
numbers for qualified children; failure to report income; and dependent
children who were ineligible for purposes of the credit.

If you qualify
for the EITC, pay attention to the fine print. Report all your income;
check and double check your math (see number one above).

4. Live
within your means.
Even if you’re not too rich or too poor,
make sure your tax return accurately reflects your economic reality.
It doesn’t make sense for you to report $30,000 in charitable donations
on a $45,000 salary – or home mortgage interest deductions
of $10,000 for your $15,000 job. Think about the picture you’re
painting on your return: Does it make sense?

The IRS has
a database, of sorts, of what it thinks it takes to survive based
on where you live and the number of dependents you report. If your
numbers are wildly different from those norms, it will question
whether you are under reporting income or over reporting deductions.
Just ask Rachel
Porcaro
, the Seattle mother of two boys, who was flagged for
audit because the IRS did not understand how she could support her
family on her salary.

The bottom
line when it comes to reporting income and expenses: Your tax return
shouldn’t raise more questions than it answers.

5. Don’t
lose money.
I’ve already alluded to the fact that filing a Schedule
C may increase your risk of audit. This is because, according to
a recent Government Accountability Office report, the IRS estimates
that as many of 70% of taxpayers who report net losses on a Schedule
C have artificially inflated expenses to create losses.

The IRS understands
you will have years that are good and years that are not so good.
But it likes to think you’re in business to make a profit, even
if you don’t every single year. If, however, you’re reporting losses
on your Schedule C every year (especially for three or more years
in a row), the IRS might question how you’re managing to get by.
Expect the agency to ask.

Read
the rest of the article

February
5, 2010

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