There's no surefire way to avoid the nightmare millions of taxpayers fear: an IRS audit. But there are a lot of ways to reduce the risk.
A couple of years ago, we wrote a story about your odds of being audited by the IRS and concluded most people making less than $200,000 have about a 1 percent chance.
But those odds may have increased since IRS stepped up its game. And it’s easy to see why. A recent update to the IRS’ tax gap estimate (“defined as the amount of tax liability faced by taxpayers that is not paid on time”) showed a gaping hole of $345 billion in 2001 that widened to $450 billion in 2006, the last year they computed it.
That means the total in unpaid taxes jumped 30 percent in five years – and it’s probably even higher now. With today’s historic deficits, it’s not surprising Uncle Sam is looking harder for some cash.
While nobody outside the IRS knows which returns will be under the magnifying glass, there are two things we know for sure. First, there’s no guaranteed way to avoid an audit (no matter what anybody tells you) because the government admits to randomly picking thousands of people every year. From the top of the tax gap estimate report just mentioned: “Beginning with TY2006, the IRS is undertaking each year approximately 14,000 returns for individual income tax research audits (that is, random audits.)”
The other thing we know for sure: Certain tax decisions increase the risk of being audited. 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, and look for more advice on the other side…
As Stacy suggested, take the deductions you’re entitled to. An audit doesn’t mean you’re guilty, or even that the IRS is suspicious – just that they want 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…
- Be careful with pros. Many people don’t need to hire a tax professional, because the IRS offers free help for those making less than $50,000 a year. But if you do, choose wisely based on references and credentials. If the IRS suspects a tax preparer is fudging numbers, they might audit all his clients. Learn how to pick a pro in Tax Hacks 2012 – Should You Hire Help?
- Business before pleasure. You can, and should, deduct expenses related to a business. But hobby expenses 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.”
- Incorporate. As Stacy mentioned, the self-employed are 10 times more likely to get audited if they file a Schedule C than an S corporation 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.)
- Avoid outsized deductions. Another red flag Stacy mentioned 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 more money involved, the more likely an audit becomes. 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.
- Take your time. Don’t rush filing your taxes – the more mistakes you make, the more your return sticks out. We just covered the most common in 11 Common Mistakes That Can Cost You, like forgetting to sign your return or getting your Social Security number wrong.
- 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. The odds of an audit for incomes over $200,000 jump to about 3 percent, and for those making more than $1 million, it’s more than 8 percent.
- Be careful with the earned income credit. The IRS, however, doesn’t favor lower-income taxpayers either. Folks who claim the Earned Income Tax Credit can also invite scrutiny. More than 26 million people claimed the EITC last year, leading to $58 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.
- Report all income. As Stacy pointed out in Profile of the American Tax Cheat, many people don’t realize income from almost any source is taxable. You won’t 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 that because you didn’t get a copy, one wasn’t filed with the IRS. If your W-2, 1099, or other tax form hasn’t shown up by Feb. 15, call the company that’s supposed to be sending it. Still no luck? Call the IRS at (800) 829-1040.
- 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: “E-file benefits include a reduced error rate (1 percent compared to nearly 20 percent on a paper return), which means a decreased likelihood of hearing from the IRS. Also, federal tax returns are delivered to the IRS through a highly secure, encrypted transmission system.” Easier, cheaper, safer, faster refunds – there’s no good reason not to file electronically.
- 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.
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 number might be the IRS’ idea of a joke, but the service isn’t. The taxpayer advocate service is an independent faction of the IRS that can help people who can’t afford professional representation to work things out.