7 Steps to Avoid a Tax Audit
One of the most dreaded outcomes of filing your taxes is receiving notification that the Internal Revenue Service would like to administer a tax audit on you or your business. In the simplest terms, a tax audit is an examination of your tax returns to verify that your income and deductions are accurate. The IRS examines your tax returns in great detail to determine if the financial information you provided was reported correctly.
A recent IRS trend shows that correspondence and in-person audits are on the rise, especially among high income earners. However, high income earners are not the only taxpayers who can be selected for an audit. You can be selected for a tax audit for a number of reasons including random selection, computer screening where a mathematical reconciliation error has occurred, document matching reasons, unusual or excessive use of deductions, recent tax returns filed in bulk, or a related audit or collection case being worked by the IRS, among others.
While many believe you should be fearful of the auditing process, it’s not as daunting as it may seem. Most people are only required to answer a few additional questions and the issue may be very simple and easy to resolve. Regardless of the issue, you can reduce your chances of being audited by following these 7 steps.
1. Know If You’re a Target: As we mentioned above, there are several different ways the IRS selects individuals for an audit. While the process can be random, the IRS has a system called the Discriminant Income Function (DIF), which is used to flag potential audits. The statistical system compares your deductions with others in your income bracket.
If you own a business, you should be prepared that you could potentially be a target. Recently, Congress has been restricting the IRS budget causing the IRS to carefully select where they spend their money on audits. As a result of the smaller budget, the IRS has been choosing to audit businesses as a way to get more value out of their costs.
It’s also important to understand the IRS process and what is often questioned. The most common flags for an audit include extreme debt expenses, casualty losses, home office deductions, medical expenses, business travel, and meals and entertainment. While you can’t completely eliminate your chances of being selected for an audit, you can lower your odds by keeping proper documentation and following the remainder of the steps.
2. Keep Good Records: If the IRS sees discrepancies in your income, especially if you’re a business owner with a large number of cash transactions, you have a higher chance of being audited. In order to avoid the audit, keep good records. Save all receipts from expenses and charitable donations.
Many individuals use charitable donations as deductions from their income but fail to obtain the required documentation of these donations. In order to avoid an audit, obtain a receipt and keep all records from all charitable donations you claim.
Additionally, if you’ve worked with an accountant or lawyer throughout the course of the year, keep records of your meetings including the date and reason. If you’ve relied on expert advice and an issue arises, you may be able to get penalties waived based on good faith reliance in an independent expert.
3. Report All Income: As we previously mentioned, the IRS has a tracking system in place to determine which income tax returns to audit. The system gives tax returns two scores: one based on whether or not it should be audited and one based on the likelihood of unreported income. With a highly advanced tracking system in place, it is extremely important to report all of your income in order to avoid an audit.
As an individual or business, you must report all income and do so correctly. Some individuals believe that because the risk of an audit is small, they can get away with fudging small numbers. You will always attract the attention of the IRS if you fail to report all of your income, fail to report payments to household help, fail to report large gifts or not pay tax on income earned abroad. The risk is truly not worth it so if you want to avoid an audit completely, report all income.
4. Understand Business Expenses: If you own a business, you’re able to deduct several business expenses including meals, entertainment and home office expenses, among others. It’s important to fully understand what is and what isn’t considered a business expense as the IRS often double-checks these types of deductions to ensure they are legitimate business expenses.
If you’re self-employed but don’t earn much income, it can also raise red flags with the IRS, especially if you claim your home office and other business expenses. It’s very important to keep track of all paperwork and records so you can clearly defend any deductions and credits.
5. File Properly & Completely: One of the most common mistakes is incorrectly filing IRS paperwork. When you make mistakes on the paperwork or leave portions of the form blank, it commonly triggers an audit. In order to avoid an audit, answer every question and fill in every line even if it’s with a zero or a dash. Additionally, either type your returns or write neatly. If the IRS can’t read your form, they may find it suspicious and flag it for an audit.
6. Check Your Math: A significant amount of people are audited due to mundane math errors. If the numbers of your forms don’t match or add up correctly, the IRS will likely notice. Use exact numbers rather than rounding, and double-check everything.
7. Update the IRS: Life-changing events such as marriage, divorce, the birth of a child or purchasing a home can all change your tax status, so it’s important to account for these changes. Additionally, if you move, send a change of address form 8822 to the IRS. The IRS sends paperwork to the last known address so if you don’t change your address, you could miss important documentation from the IRS.
While the IRS only audits 1 percent of the population and only a fraction of those people require a face-to-face meeting with an IRS agent, it’s best to avoid the auditing process altogether .
If you have received a letter or phone call from the IRS requesting an audit, contact a professional as quickly as possible. For immediate audit assistance from our former IRS Auditors and CPAs, contact us today at 1-714-382-6780 for a FREE and CONFIDENTIAL consultation.