Ways to Avoid a Tax Audit

Worried about extra scrutiny from the IRS? While you can never “audit-proof” your income tax return, you can take actions that will greatly reduce your chances of being flagged.

Here are ways to avoid a tax audit:

Report all of your income: The IRS uses information returns, such as W-2’s and 1099’s to cross-check income reporting. Under its document-matching program, the IRS’ computers compare information on the forms with the income reported by taxpayers on their returns. If the information doesn’t match, this leads to an automatic audit.

  1. Provide complete information: All questions should be answered and all required information should be included on the forms and schedules as necessary for your return. If information is missing, it could trigger a more extensive look at the return.
  2. Avoid claiming deductions that are audit red flags: Unfortunately, the IRS does not say which deductions are likely to provoke a closer look. There are no official audit red flags. However, follow this rule, if you meet the qualifications for claiming a deduction, there is no good reason not to take the write-off. Some tax professionals believe that taking more than the “average” can raise an IRS eyebrow, but again there is no evidence to support it. If you are qualified for the deductions, even if they are high relative to the amount of the income, you should claim them-but be prepared to prove entitlement if the return is questioned.
  3. Don’t file certain forms or schedules: Some optional forms and schedules virtually guarantee an audit. For example, if you turn a hobby into a sideline and show a business loan, the IRS may question whether some of your deductions are legitimate. It that happens, you might file a Form 5213, which keeps the IRS from auditing you for the first five years of the business. If you can show that you are profitable in at least three of the years, then the business isn’t a hobby and the losses in the other years aren’t questioned. The problem: Filing the form virtually guarantees an examination at the end of five years.
  4. Pay attention to details: Math errors or incorrect entries of Social Security numbers or tax identification numbers can easily trigger an inquiry into your return.
  5. Mind your personal entries: If there are entries related to the personal side of your return, this can ultimately lead to scrutiny of your return activities. The IRS selects returns for audit in some cases based on a Discriminant Function System or DIF score, which is based on IRS experience with taxpayers claiming certain deductions or credits within set income levels. For example, if you claim charitable contributions that are higher than the average deductions for your income level, this could lead to a personal audit; the personal audit may be expanded to include your business activities.
  6. Change your business status: IRS statistics show that you are 10 times as likely to be audited as a Schedule C filer than if you incorporate your business and elect S corporation status. While it costs a bit of money to incorporate, the move affords you greater personal liability protection and reduces your chances of being audited. In deciding whether to change your business status, include both tax and non-tax factors.
  7. Watch your state tax return: The IRS has information-sharing agreements with the states. If you are audited at the state level and owe additional taxes because of omitting income or for other reasons, this information is shared with the IRS. The information may then prompt the IRS to contact you asking for additional tax payment or to audit your return in more depth.
  8. Plan for an Audit, just in case. Because the IRS conducts random audits from time to time (such as a three-year random audit program for S corporations in 2007 and a current three-year random audit program for employment tax returns), any return could be selected for review at any time. Be prepared:
  • Compile good books and records.
  • Retain required receipts and other documentation.
  • Use separate bank accounts and credit cards for your business and personal activities.

Retain the records and receipts for your tax return for a minimum of three years (the period in which the IRS usually has to audit a return). However, keep in mind that the period becomes six years if 25% or more of income is omitted from the return, and there is no limit when it comes to fraud.

…Taken from the Wall Street Journal by Barbara Weltman

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