While fewer than 1 percent of all tax returns are audited, there’s no guarantee you won’t appear on the IRS’ radar. But there are ways to reduce the risk.
By Allison Martin, MSN Money Partner
Wouldn’t it be nice if the IRS released its secret formula for how it selects individual tax returns for audit? That way, we’d do everything we could to stay under the radar and not be selected for further review.
Fewer than 1 percent of tax returns are audited, which is good news for all. But there’s no way to guarantee you’ll be exempt from the IRS’ prying eyes, so all you can do is take the proper precautions and hope for the best.
1. Shady preparers
If you don’t prepare your own return or take advantage of the free help that is available if you make $52,000 or less, chances are you will entrust someone else with your information to prepare your return. Just make sure the individual is legitimate, or you may end up in the IRS’ hot seat.
How do you spot a shady preparer? If they make ridiculous claims, like guaranteeing that all of their clients will get refunds, you definitely want to seek other options.
2. Business or hobby?
Have you been in business for at least three years and your tax return still reflects a loss? Chances are the IRS may view your business activity as a hobby, which is another red flag.
And if you used a Schedule C to claim your losses instead of incorporating, that also increases your chances of being placed under a microscope by the IRS.
So, what are you to do if your business is really losing money because it’s a startup or as a result of economic conditions? Take the deductions you are entitled to, but maintain adequate documentation to substantiate your claims.
3. Too much generosity
Perhaps 2013 was the year of giving, and you doled out large sums of cash that were disproportionate to your income? Your actions may raise a few eyebrows at Uncle Sam’s headquarters.
According to IRS Publication 526, charitable deductions are limited to 50 percent of your adjusted gross income, with 20 and 30 percent limitations applied in some cases. And if your individual contributions are $250 or more, you must keep a bank record showing the donation or a document that includes your name, the date the gift was given and the amount.
4. Cash earners beware
If you are employed in a position that works for tips, such as a bartender or restaurant server, it is important to understand that all tips received must be reported as income; it is against the law to do otherwise.
While it may be possible to understate income, the IRS has a certain threshold that it expects servers to meet, and any amount substantially less may raise a high level of concern, and possibly trigger an audit.
5. Typographical errors
Didn’t double-check your tax return for accuracy? The IRS may be coming for you if mistakes are present.
Common audit flags include incorrect Social Security numbers and employer identification numbers, transposed figures and mathematical errors on the face of the return. Word to the wise: Review your return carefully to ensure that the information you plan to submit matches the corresponding tax documents, as a simple mistake can land you on the audit list.
. Unreported income
What the IRS has on file should match the face of your return, so refrain from omitting any form of income that you earned. And don’t assume that because the company didn’t give you a W-2 or a 1099 statement, you’re off the hook, because it more than likely wrote off the expense.
Having a hard time retrieving the documents? Give the company a ring. Still no luck? Call the IRS and I’m almost certain they’d be happy to assist.
7. Tax credits
Unfortunately, shady tax professionals can use tax credits to make good on fraudulent promises. For instance, improper use of the Earned Income Tax Credit amounts to more than $10 billion a year. The Wall Street Journal says:
The EITC’s complex rules help lead to high error rates by taxpayers and even paid preparers. It’s also vulnerable to fraudulent claims, despite some elaborate safeguards that have been built in over the years.
The Journal also says:
The IRS said in (a) statement Monday: “Every year, the IRS conducts 500,000 EITC audits as part of a broader enforcement strategy, and EITC claims are twice as likely to be audited as other tax returns.”
Of course, it’s OK to claim credits that you are indeed eligible for, but be sure to read the IRS guidance to ensure you qualify.
8. High income
Making more money may cause problems, at least from an audit risk perspective. CNBC says:
People who earn more than $1 million a year are more than 12 times more likely to be audited than people who earn $200,000 or less. About one of every eight tax filers making $1 million or more were audited in 2011 — double the rate of 2009.
But a new report says the IRS should be targeting the wealthy even more.
Check out this 2012 chart on CNNMoney about the chances of being audited broken down by income.
I’ve been selected for an audit. Help!
If the folks at the IRS decide you are the perfect candidate for an audit, take a deep breath and relax, as an audit does not mean you are doomed. Reply to the questions in their interview in the best manner possible, and use the documentation you have on hand as supporting evidence if requested.
Also, take a look at the IRS literature on audits along with this video to learn more about the process. And if you need assistance, be sure to complete the Request for Taxpayer Advocate Service Assistant, or Form 911 (.pdf file).