Avoiding an Income Tax Audit
If filing taxes wasn't tolling enough, taxpayers also face the possibility of an income tax audit by the Internal Revenue Service (IRS). While certain tax returns may be chosen for an audit because they raise red flags, are randomly selected, part of a target group (and thus subject to more scrutiny), , or a combination of the above; that is not true for all cases. In fact, there does not seem to be definitive advice, that if heeded, would guarantee taxpayers that they will not face an income tax audit.
While there's no guarantee against an IRS audit, there are strategies you can employ to "play the odds" and reduce your chances of receiving the dreaded Notice of Audit. Some are obvious, others less so, but what they all have in common is to be honest about what you put on your tax return and how you submit it and to avoid fraud
Some common mistakes and red flags which attract IRS attention for an income tax audit include:
- Math errors--one of the most common errors is also the easiest to fix. Don't expect the IRS to reason that the reason you think you don't owe taxes is because you simply made a math mistake. Double and triple check your figures. Automated tax return programs such as TurboTax are useful in avoiding such errors.
- Omitting income--another simple error that points the IRS in your direction. Even omitting a small amount may trigger IRS interest, so be sure to collect all your documentation from stocks, bonds, interest bearing accounts, etc. This is especially true for those making over $100,000--the IRS has been targeting those making over this amount in the past several years.
- Claiming false business expenses--people will often use business funds to pay for personal purposes. But if you characterize the use as a business expense, then the IRS may view it as failing to report additional income.
- Filing returns as "self employed" (Schedule C filers)--this is a favorite and easy target for the IRS. Because of the ready potential for hiding income by making it look like a business loss, the IRS always has its eyes out for Schedule Cs that show a loss. The IRS knows how tempting and simple it is to make personal expenses look like business expenses on a Schedule C, and pay appropriate attention.
- Target groups--the IRS looks for incongruent returns from the self employed, small businesses, and those who make over $100,000. The IRS also targets tax returns that are disproportionate to returns from others with a similar income, location, profession, and/or family size. For example, if you claim a family of six and live in a home in Beverly Hills, but only claim income of $25,000, the IRS will likely investigate the claim.
- Talking too much--if you do choose to scam the IRS,you can be caught by anyone willing to tip off the IRS to your illegal act. Whistleblowers can receive a percentage of the additional tax collected based on the tip.
Some of the "red flags" from above, can't be helped. If you're a small business, you have to file as a small business. Just be prepared in the event that the IRS does tap you on the shoulder for an income tax audit
Staying Off the IRS Radar
In addition to avoiding the above mistakes and red flags, wherever possible you should hire a bookkeeper to make sure receivables, credits, and debits are all in order. This is especially true for small businesses. Additionally, unless you have a very straightforward tax return (i.e., a W-2 and nothing else), you should also consider hiring a tax professional to handle your tax return. Tax preparation software's has limited effectiveness for anything beyond a W-2.
Another tip is to prepare your taxes on a computer. The IRS favors computer processed returns, and they are clear and easy to read. If you can't use a computer, print carefully. You might want to make two copies--one a first draft where you can cross things off and make corrections, and a second final draft where you carefully write down your final tabulations. There's nothing like a sloppily written return to draw attention to your return.
And finally, and obviously, always file your taxes on time. If you owe money and can't afford the entire payment, at least send a nominal amount so the IRS records the receipt of a payment (the payment also indicates good faith on your part). Filing a tax return extension only extends the deadline to file your taxes, not the deadline to pay them. If you file on time and send at least a small payment, you save 25% on IRS late fees. So do yourself a favor and file and pay at least a portion of what you owe on time.
Receiving a Notice of an Income Tax Audit
If you do happen to be audited, don't panic. If you have all your documentation and make the proper calculations, deductions, and write-offs, you'll be fine and the IRS will end its investigation. An audit is simply the IRS asking you to prove the numbers on your return.
There are three types of income tax audits--correspondence, field, and in-office. A correspondence audit is the most common type and generally the most simple to deal with. It usually involves the IRS taking note of a correction (their gentle word for, "error") on your return with a notice to either pay more or clarify by providing them with more information. A field audit typically happens for businesses and not individuals and involves a team of IRS auditors going on-site to the business and inspecting their books and documentation. An in-office audit is conducted in the IRS office and requires the business or individual to prove their tax return is true and correct.
For anything other than a correspondence audit, you should consult a tax professional who can guide you through the process and prepare you for the audit. Of course, you can also retain a professional for a correspondence audit as well, but as stated, they are generally more straightforward. For field and in-office audits, think of the income tax audit as a trial--you always want someone representing you. Get a professional to assist your case.