No one wants to see the IRS knocking at their door, requesting an audit of a prior year tax return. Sometimes, it's just the luck of the draw. But there are things that you can do (and NOT DO!!!) to decrease your chances of being audited.
Who is audited? Estimates vary but approximately 1 to 1.5 percent of all taxpayers are audited. Most tax returns singled out by the IRS for audit contain either tax deductions that appear to be too high in relationship to the person's income, or tax items that are erroneous, tax items that require proof or an explanation, or are on the IRS' list of hot tax issues. About 16 million tax returns each year are tagged as having a potential discrepancy -- out of 140 million returns filed in 2008. Of those approximately one third are actually reviewed by an auditor.
What happens with pulled returns varies from taxpayer to taxpayer based on your individual circumstances. You may simply receive a notice that your taxes have been recalculated with a request for more money. If there is a question about a specific deduction or expense, you may receive a request for more information. In some cases, you will be asked to sit down with an IRS examiner and answer questions and provide more information in person.
Why Me? Contrary to popular belief, the method used to submit your return is not a factor in the audit selection process. The selection is done after the data is entered, whether via e-filed return or the return being input by an employee. The IRS selects returns for examination based on a weighted analysis of the data provided on your return. For example, if your Adjusted Gross Income is $200,000 and your charitable contributions are $10,000, you would receive a low "weight" to your data. However, if your Adjusted Gross Income is $50,000 with the same $10,000 amount of charitable contributions, a "heavy" weight is assigned. The IRS selection process will give a higher score to the person with the lower income, even though the amount of the deduction is the same. Every line on the return is "scored" on a weighted scale and the weight varies based on the other factors on your return, like AGI or filing status. The weighted values are added together and a number is generated. Larger numbers have a great chance of an audit.
The High-Risk Audit Areas:
1. High Wages
IRS Audit Statistics
Income for Tax Returns
Tax Returns Filed
Tax Returns Examined
Percent Examined
Less Than $25,000
59,211,700
1,076,945
.81%
$25,000 to $50,000
27,263,000
259,794
.58%
$50,000 to $100,000
17,019,200
196,582
.62%
Greater Than 100,000
4,540,800
129,320
1.66%
As for the higher earners, returns showing income of $200,000 and above have a nearly 3 percent audit chance. The percentage jumps to more than 6 percent for returns with earnings of $1 million or more.
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2. High Itemized Personal Deductions
You have large amounts of itemized deductions on your tax return that exceed IRS targets.
If your itemized tax deductions on your tax return exceed a target range as set by the IRS, the chances of being audited by the IRS increase. This is especially true if you claim large cash contributions to charities in relation to your income on your tax return. This does not mean that you should not take tax deductions on your tax return that you are entitled to, but you should realize that your chances for an audit increase if your tax deductions exceed the averages for your income level.
3. Tax Shelter Losses
You claim tax shelter investment losses on your tax return particularly if one or both taxpayers have high income from other sources. The IRS will question whether there is an attempt to use the horse business as a tax shelter.
4. Complex Expenses/Transactions
You have complex investment or business expenses or other transactions on your tax return.
5. Cash used routinely in your business
You own or work in a business which receives cash and/or tips in the ordinary course of business. Lesson income is definitely an example of a cash business so be sure that your day sheets include a list of checks received and those checks tie into your bank deposits.
6. High Business Expenses
Your business expenses are large in relation to your income on your tax return or show losses continually, year after year.
7. Rental Property
You have rental expenses on your tax return.
8. Prior/Related audit
A prior IRS audit resulted in a tax deficiency or you are a shareholder or partner in an audited partnership or corporation.
9. Unreported Taxable IncomeThe IRS discovers unreported taxable income when its computers match the taxable income you reported on your tax return with information gathered from banks, brokerages and customers of independent contractors. The most common example of this is unreported bank interest. To help avoid omitting income on your return, review last year's tax return to make sure you have the necessary 1099's, etc. from mutual funds, banks and other sources . Report income exactly as it appears on the 1099 Form.
10. Self Employment
The IRS believes most under-reporting of taxable income and abuse of tax deductions occurs among those who are self employed so they are audited by the IRS more frequently than employees. The temptation with some who are self employed is to deduct personal as well as business expenses on their tax return. Be sure there is a true business purposes for each expense.
The audit rate for self employed entities is greatest among sole proprietors. In 2008, a sole proprietor with gross receipts of between $100,000 and $200,000 had an audit rate of 3.9%. To minimize your risk of audit, consider changing your entity. You can, for example, incorporate and use S corporation status. The audit rates on S corporations, even if they are one-owner entities, are dramatically lower than the rates on sole proprietorships (S Corp audit rate was only 0.4% in 2008).
11. High Auto MileageOne of the most commonly audited items for self employeds and employees of companies who use their car in business is the deduction for business transportation. You need to keep good records of all tax deductible automobile expenses and a mileage log showing business miles driven. Try to keep the mileage log on a daily basis including the date, beginning and ending odometer readings, the location, the business purpose, and the client. At a minimum, record the automobile's odometer reading at the beginning and end of the tax year and have a calendar that you could use to reconstruct your deduction.
The IRS reviews your return to determine its accuracy. As a taxpayer, you have the burden of proof that your return is accurate. However an audit can be a time-consuming and frustrating process. Here are some steps you can take to avoid an audit:
Document All Income and Deductions-You can verify income, profits and earnings with supporting documentation. Large tax deductions are audit red flags, so make sure all are well-documented. If you think that there is anything on your tax return that may cause the IRS to take second look, attach a copy of the invoice or paid bill in question. Check the Numbers-You are ultimately responsible for what is on your returnso be sure to check that you or the preparer have entered the numbers correctly. I've seen $1,700 entered as $17,000 for farrier expense. The tax preparer reviewing the return didn't know what a farrier was and so the expense didn't look out of line to him. It definitely caught the attention of the IRS and an audit followed.
Use Your Common Sense- File your taxes on time and answer all of the questions asked. The cleaner the return, the less likely you are to attract the attention of the IRS.
Best Practices-Keep good records of your business activities: locations, times and dates, expenses, a description of what took place, along with accompanying receipts and cancelled checks. If you are audited, you have most of the work already done.
Report all your income-You are required to report all business income unless a special tax rule on tax-free treatment applies. So:
· Report "invisible" income- If you barter for goods and services, you are taxed on the value of what you received in the trade.
· Report cash-Tips and other cash payments are something that the IRS is focusing on. Based on your lifestyle and expenses, they can determine if you have been receiving additional income in the form of cash. This is particularly true in industries where payment in cash is common.
Keep the paperwork-Your records are the key to proving your right to deductions and credits. You may not be able to prevent a random audit but you will be able to survive it if paperwork is on your side. Types of records:
Receipts, invoices, and canceled checks for expenses paid.
Expense account worksheets, diaries and log books for travel and entertainment costs, including car usage.
Financial experts expect to see an increase in audits and assessments in the coming years because tax audits provide a revenue stream that the IRS currently is missing out on. The IRS estimates that it fails to collect about $345 billion in taxes each year. So it's even more important now that you keep clean, accurate records and understand what factors can cause your return to be audited.
When you first learned to ride, you learned how to do an emergency dismount and use a pulley rein to stop a runaway horse. Hopefully, you'll never have to use that knowledge but you are prepared - just in case. Think of this information as your audit "pulley rein".