10 Tips to Avoid an Audit

What are the odds of being audited by the IRS? If you make less than $200,000 a year, just over 1 in 100, according to their annual report.

Those odds are up slightly over the past six years, where the average audit rate was 0.98 percent. That’s because the IRS stepped up its game a few years ago to work on closing the tax gap, or “the amount of tax liability faced by taxpayers that is not paid on time.” That amount was $345 billion in 2001, rising to $450 billion in 2006, the last year they computed it.

With today’s historic deficits, it’s not surprising Uncle Sam is looking harder for missing cash. There’s no guaranteed way to avoid an audit, because the government admits to randomly picking thousands of people every year. But there are ways to avoid red flags – things that make your return suspect and more likely to be chosen for an audit.

In the video below, Money Talks News founder and CPA Stacy Johnson offers three tips to avoid receiving a notice from the IRS. Check it out, then find more advice on the other side…

As Stacy suggested, always take the deductions you’re entitled to. An audit doesn’t mean you’re guilty of anything – it just means the IRS might need a closer look. Good documentation is your best defense, so stay organized and don’t throw anything out until you know you won’t need it. The IRS typically has up to three years to audit a return, although they go back further in some cases. Here’s a recap of the tips you saw in the video, along with a few more…

1. Be careful with pros

Many people don’t need to hire a tax professional – there’s free professional preparation for those making $51,000 a year or less. But if you do decide to pay for help, choose wisely. Check references and credentials: If the IRS suspects a tax preparer is routinely fudging numbers, they can audit all their clients.

2. Put business before pleasure

You can and should deduct expenses related to a business, including for home office use if it applies. But expenses related to hobbies aren’t deductible. The difference: A business makes money. From the IRS page called Is Your Hobby a For-Profit Endeavor?: “An activity is presumed for profit if it makes a profit in at least three of the last five tax years.”

3. Incorporate

As Stacy mentioned, according to The Wall Street Journal, self-employeds are 10 times more likely to get audited if they file a Schedule C rather than a corporate return. The reason is partially explained by a line in this government study: “70 percent of the sole proprietor tax returns reporting losses had losses that were either fully or partially noncompliant.” In other words, people operating a hobby rather than a business are more likely to file a Schedule C.

Taxes aren’t the only factor in the decision to incorporate. Read How Should You Set Up Your Business? for more options, with pros and cons on each.

4. Avoid outsized deductions

Another red flag is taking charitable deductions that look big compared to your income. In general, the IRS says you can deduct up to half your adjusted gross income. But the rules get complicated, and the bigger the deduction, the higher the audit odds. That doesn’t mean you shouldn’t take all the deductions you’re entitled to – it just means you should be prepared to back them up.

5. Take your time

Don’t rush through your taxes – the more mistakes you make, the more your return sticks out. We’ll soon cover the most common tax mistakes, but if you can’t wait to file, don’t miss simple stuff like signing your return and double-checking your Social Security number.

6. Make less

Prolific U.S. bank robber Willie Sutton was credited with saying he robbed banks “because that’s where the money is.” The IRS has a similar philosophy. Last year the odds of an audit went up sharply for higher earners. Audit odds for those making more than $200,000 were about 4 percent, and for those making more than $1 million, more than 12 percent.

We’re not seriously suggesting taking a pay cut to lower your audit risk. But the more you make, the better prepared you should be.

7. Be careful with the earned income credit

The IRS doesn’t focus only on the rich. Folks claiming the Earned Income Tax Credit – available to “low to moderate income working individuals and families” – can also invite scrutiny. More than 27 million people claimed the EITC last year, leading to $62 billion in refunds. Because the credit is refundable – meaning the government will send you a check even if you paid no taxes – it’s ripe for abuse. Definitely take it if you’re eligible, but make sure you are. Check out the EITC page of IRS.gov for more.

8. Report all income

Many people don’t realize income from almost any source is taxable. You may not get caught on stuff like yard sale profits, but you might on gambling winnings. And for stuff that’s been reported to the IRS by someone else – like investment and self-employment income – you almost certainly will.

Don’t assume because you didn’t get a copy of an income-reporting form, one wasn’t filed with the IRS. If your W-2, 1099, or other tax form hasn’t shown up by now, call the company that’s supposed to be sending it. Still no luck? Call the IRS at (800) 829-1040.

9. E-file

It’s true that the IRS uses computers to analyze returns for potential audits. But it’s not true that e-filing increases your risk. In fact, the IRS says the opposite: When you e-file, “Your chance of getting an error notice from the IRS is significantly reduced.”

It’s easier, cheaper, safer, and gets faster refunds – there’s no good reason not to file electronically.

10. Be careful with state returns

Federal and state governments communicate, so if you get audited by one, expect to hear from the other. That’s a good reason to take just as much care in preparing a state return as the federal one.

What if I get picked anyway?

Keep calm and carry on. An audit isn’t the end of the world. The IRS has a video series explaining the whole audit process in detail. Usually it’s a polite notice or phone call asking for some details about a few numbers on your return. It rarely requires an in-person interview or an agent showing up at your door.

If you do get selected for an audit, don’t forget about Form 911: the form to request help from the Taxpayer Advocate Service. The number might be the IRS’s idea of a joke, but the service isn’t. The taxpayer advocate service is an independent department of the IRS that helps people who can’t afford professional representation.

Have you ever been audited? Tell us about your experience below or on our Facebook page.