Top 10 Ways To Avoid a Tax Audit

     

"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:

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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.

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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.

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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).

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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.

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February 5, 2010