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If history is any indicator, less than 1% of Americans will be audited by the Internal Revenue Service
in the coming year. And while some of these audits are totally random,
and there's nothing that the individual taxpayer can do about them,
many audits are actually instigated by the taxpayers themselves.
To that end, below is a list of "red flags" that can cause your return to be cherry picked by the IRS for review. Pay particular attention, as knowing what the flags are can keep you out of trouble.
1. Overestimating Donated Amounts
The
IRS encourages individuals to donate things like clothes, food and even
old automobiles to charities. It does this by offering a deduction in
return for a donation. However, the problem with this system is that it
is up to the taxpayer to determine the value of goods that are donated.
As a general rule, the IRS likes to see individuals value the items they donate at anywhere between 1% and 30% of the original
purchase price (unless special circumstances exist). Unfortunately
many, if not most, taxpayers either aren't aware of this, or simply
choose to ignore this fact.
There are several other tips that the
taxpayer can use to ensure that he or she is valuing donated goods at a
"fair" price. Aside from the 30% and under rule mentioned above,
consider having an appraiser write a letter. (In fact, for individual
items valued at $5,000 or more, an appraisal is required.). Another benchmark the IRS uses that could come in handy is the willing-buyer-willing-seller test.
This
means that taxpayers should value their goods at a point or price where
a willing seller (who is under no duress) would be able to sell his
property to a willing buyer (who also is under no duress to purchase
the item). Using such a benchmark will keep you out of trouble and prevent you from placing an excessive value on your dad's old Frank Sinatra albums.
2. Math Errors
While
this may sound simple, many returns are selected for audit due to basic
math errors. So when filling out your tax return (or checking it after
your accountant has completed the form) make sure that the columns add
up. Also make sure that the total dollar value of capital gains and/or
losses are properly calculated. Even a small error can raise eyebrows.
3. Failure to Sign the Return
A
large percentage of folks simply forget to sign their tax returns.
Don't be a part of that number! Failure to sign the return will almost
guarantee that it will receive additional scrutiny. The IRS will wonder
what else you might have forgotten to include in the return.
4. Under-Reporting Income
Tempting
as it might be to exclude income from your tax return, it is vital that
you report all money that you received throughout the year from work
and/or from the sale of an asset (such as a home) to the IRS. If you
fail to report income and you are caught, you will be forced to pay
back-taxes plus penalties and interest.
How can the IRS tell if
you've reported everything? In some situations it can't. After all, the
system isn't perfect. However, a common way some individuals get caught
is that they accept cash for a service they've performed. If the
customer or individual who paid that individual the cash gets audited,
the IRS will see a large cash disbursement from his or her bank
account. The IRS agent will then follow that lead and ask the
individual what that cash layout was for. Inevitably, the trail leads
right back to the individual who failed to report that money as income.
In short, it's better to be safe than sorry. Make sure you report all of your income.
5. Home Office Deductions
Be
careful with home office deductions. Excessive or unwarranted
deductions can raise red flags. In addition, large deductions in
proportion to your income can raise the ire of the IRS as well.
For
example, if you earned $50,000 as an accountant (operating from home),
home-office related deductions totaling $30,000 will raise more than a
few eyebrows. Trying to write off the value of a new bedroom set as
office equipment could also draw unwanted attention.
Deduct only items that were used in the course of your business.
6. Income Thresholds
There
is nothing the individual taxpayer can do about this one, but if you
earn more than $100,000 each year, your odds of being audited increase
exponentially. In fact, some accountants put the odds of being audited
at one in 72, compared to the one in 154 odds for people with lower
incomes.
Other Sensitive Tax Areas
Partnership/Trust/Tax Shelter Risk
If
you own shares in a limited partnership, control a trust or partake in
any other tax shelter investments, you are more apt to be audited.
While there may be no way to avoid such an audit, individuals that have
a stake in such an entity should be aware that they have a target on their backs. They should also take even greater care to document deductions, donations and income.
Small Business Ownership
Small business owners are an easy target
- particularly those with cash businesses. Bars, restaurants, car
washes and hair salons are exceptionally big targets, not only because
they deal in so much cash, but also because there is so much temptation
to under-report income and tips earned.
Incidentally, other
actions that go part and parcel with business ownership may draw
unwanted IRS interest too, including putting family members on the
payroll and over-estimating expenses.
In short, business owners
must know that they can't "push the envelope". If they want to stay in
business and avoid the scrutiny of an audit, it's best to remain on the
straight and narrow.
So why does the IRS seem to be cracking down
more and more on individuals and small business owners these days? It's
simple. According to the IRS there is roughly an annual $300 billion gap
between what Americans pay in taxes versus what they owe. That equates
to about $2,680 per household. The Congress knows this too, and given
the deficits the United States government has run up over the past 20 years, there is enormous pressure on legislators and the IRS to collect all tax funds.
Being Audited
What
should you do if you are audited? Be honest with the auditor and
respond to all inquiries as quickly as possible. Don't be afraid to
show all of your documentation. If possible, have a qualified
accountant and/or tax attorney represent you.
Bottom Line
Audits
have and will remain a part of the tax collection process for a long
time to come, but that doesn't mean that you have to be among the
"lucky" few to be chosen. The key to avoiding an audit is to be honest,
document your deductions, donations and income.
