Five Ways to Avoid Tax Audit

If the IRS does decide to audit you, there is little you may do to stop it. You may, however, reduce the odds that you’ll be singled out for that extra attention in the first place.

Staying on the right side of the IRS

While audits are rare, most Americans would probably like to avoid them altogether. The percentage of people who actually are audited is extremely small, according to the Internal Revenue Service, but the number has risen slowly since 2008. If the IRS does decide to audit you, there is little you may do to stop it. You may, however, reduce the odds that you will be singled out for that extra attention in the first place.

1. Check your figures

One of the most common red flags for auditors – erroneous data entry – is also one of the most preventable. Wait for all of your income reports, bank and investment statements and other applicable financial paperwork to arrive before starting your tax return.

Correctly reporting dependents and exemptions, as well as ensuring that the numbers match, is important because the IRS’s automated system will easily detect discrepancies.

2. Honesty is the best policy

Perhaps it’s common sense, but being 100 percent truthful on your tax return is an absolute must to reduce the chances of an audit. Realistically reporting income, deductions, credits and other figures can help keep the IRS at bay. Not reporting all of your income is a surefire way to attract attention.

Outright lying, especially if you earn a six-figure income or are hiding large sums of cash, is definitely a behavior that will get you audited. You should be prepared to look an auditor in the eye and support any number you claimed on your return. Self-employed filers, for example, should have receipts for every business deduction they claim.

3. Go vanilla

The largest pool of filers – which consists of individuals or joint filers who earned less than $200,000 but more than the lowest earners – tends to avoid overt scrutiny. Taxpayers who make more than $1 million a year and those in very low income brackets are most likely to be audited.

The wealthy take more deductions, contribute to more charities and other things so they have a higher risk of getting audited. Also, any filer who files a Schedule C (self-employment income) is about four times more likely to receive questions.

Those in what the IRS determines to be the low income bracket (a married couple with three children earning $50,270 or less in 2011) has access to the Earned Income Tax Credit.

4. Realistic deductions

Unusual or unrealistic itemized deductions, either for individuals or small business owners, may raise a red flag for auditors.

For a sole proprietor who files Schedule C, which details profits and business expenses, reporting losses for three years or more could encourage an auditor to request proof that the filer is actually in business.

Filers itemizing deductions on Schedule A must know what constitutes a legitimate deduction. Daily commuting to your regular job, for example, is not a legitimate deduction, but a special trip to meet with a potential client is.

5. E-filing helps

The Internal Revenue Service maintains that filing returns electronically can dramatically reduce errors, lowering the odds of an audit.

On Jan. 24, 1986, the IRS received its first electronically filed tax return from a preparer. By 1989, taxpayers in 36 states could file their federal taxes electronically. By 1990, taxpayers throughout the country who expected a refund could file electronically. Out of nearly 143 million individual tax returns received by the IRS in 2010, 98.7 million were e-filed.

The IRS reports that the error rate for paper return is 21 percent. The rate for returns filed electronically is 0.5 percent.

Few and far between

The word “audit” fosters trepidation in many people, but in reality the deep-tissue audits that people tend to envision are fairly rare.

In the most common federal audits, taxpayers receive notices from the IRS asking about certain details of their returns and requesting further information or clarification. This is known as a “correspondence audit.” Even these audits are rare.

By Tom Mohr, Certified Public Bookkeepers www.mohrassociates.net