How to avoid an IRS audit?

If you're audited by the IRS this year, you won't be alone. In 1997, some 1.66 million individuals were audited by the IRS, or about 1.5 percent of all taxpayers. As you can see, percentage wise, the IRS audits very few tax returns. Most tax returns singled out by the IRS for audit contain either tax deductions that appear to be too high in relationship to the person's income, or tax items that are erroneous, tax items that require proof or an explanation, or are on the IRS' list of hot tax issues. It is important that the IRS audits tax returns effectively, and the IRS puts a general fear in all taxpayers of being audited to encourage voluntary compliance with the income tax laws. The U.S. tax system depends on voluntary compliance. With today's computers there are now more ways than ever that the IRS can monitor your tax compliance.

Although the IRS audit targets change with the times, below you'll find some helpful hints as to which tax areas have commanded the IRS' audit attention in recent years. There are a host of strategies you can use to ensure you aren't selected for an IRS audit.

High-Risk Tax Audit Areas - High Wages
Generally, as your income increases, so does your chance of an IRS audit. Based on audits of 1997 tax returns, the odds of an IRS audit for someone in the $25,000 to $100,000 income bracket are less than one in 100. For those making more than $100,000, the odds increase to almost one and one half in 100.

Your chances of being audited by the IRS are greater under the following circumstances:

You must report all your income, and you should take all your tax deductions, even if they increase your chances for an IRS audit. Don't be scared off by these factors. However, also realize that your chances for an IRS audit do increase with certain tax items, and prepare your tax return accurately and completely.

High-Risk Tax Audit Areas - Large Amounts of Itemized Tax Deductions
If your itemized tax deductions on your tax return exceed a target range as set by the IRS, the chances of being audited by the IRS increase. This does not mean that you should not take tax deductions on your tax return that you are entitled to, but you should realize that your chances for an audit increase if your tax deductions exceed the averages for your income level.

Another issue to consider is excessive itemized tax deductions on your tax return. The IRS doesn't describe the criteria by which it determines when tax deductions are excessive. Some tax experts calculate average tax deductions by income, and use these figures as a rough benchmark to determine if a taxpayer's tax deductions on his/her tax return exceed the norm.

Tax experts caution that these averages may not be useful, since tax deductions vary widely by state and region. And the medical tax deductions, for instance, would by definition be much higher than the average taxpayer would take because the IRS data reflect cases where taxpayers had medical deductions exceeding 7.5% of their taxable income.

You should take valid tax deductions on your tax return if they are amply backed up.

High-Risk Tax Audit Areas - High DIF
When your tax return is filed, IRS computers compare it against the national Discriminate Information Function (DIF) system average. The IRS calculates the DIF score by using a closely-guarded formula. Tax returns with the highest DIF scores are scrutinized by experienced IRS examining officers who determine which tax returns provide the best chance for collecting additional taxes, interest, and tax penalties.

High-Risk Tax Audit Areas - Unreported Taxable Income
Unreported taxable income is a common red flag. The IRS discovers unreported taxable income when its computers match the taxable income you reported on your tax return with information gathered from banks and others. For example, if you failed to report on your tax return the interest earned on your bank savings account, the IRS typically will catch you when it matches the bank's interest payment records, called 1099 forms, against your tax return.

One good way to make sure you don't miss unreported taxable income is to review last year's tax return to make sure you have 1099's, etc. from mutual funds, banks and other sources.

The IRS electronically matches the figures you report for dividends, interest, securities transactions and other taxable income with tax information supplied by banks, brokerage firms, and other payers. To avoid problems, it's best to report your dividend and interest income exactly as it appears on your 1099 forms and make adjustments on the tax return if the numbers are incorrect. If your brokerage account files a 1099 for all your dividends, don't list separate amounts on your tax return. By the same token, if you receive separate 1099s, don't report your taxable earnings in one lump sum.

High-Risk Tax Audit Areas - Self Employment
Because the IRS believes most under-reporting of taxable income and abuse of tax deductions occurs among those who are self employed, these individuals are audited by the IRS far more frequently than employees collecting a salary. The same holds true for taxicab drivers, waiters and waitresses, and others who traditionally receive payment in cash. Also, the IRS will sometimes conduct tests of certain individuals to determine if a taxpayer's reported taxable income can support his or her lifestyle.

The IRS publishes manuals to familiarize its auditors with about 100 different businesses, particularly ones that have a high number of self employed individuals. These guides, which are available to the general public, can help you pinpoint what auditors are looking for and how best to protect yourself. To learn if a guide is available for your business click here:
Audit Guides or call the IRS Freedom of Information Act Reading Room at (202) 622-5164, or write Box 795, Ben Franklin Station, Washington, DC 20044.

High-Risk Tax Audit Areas - Home Office Tax Deductions
Home office tax deductions have been targeted by the IRS. Since the tax rules for deducting home office expenses on your tax return are complicated, you should consult a tax expert, such as a CPA, to determine whether you qualify to deduct home office expenses on your tax return.

A good example is the office in the home. By claiming such an item on your tax return, you increase your chances for an IRS audit. However, if you're clearly entitled to claim the office in the home on your tax return under the tax rules, then you should do it if it's substantial enough to make a tax difference. However, if the tax savings are minimal, then it may be wise not to claim the tax deduction at all.

High-Risk Tax Audit Areas - Unreported alimony
Over the years, the IRS has found that not all taxpayers report alimony receipts as taxable income. As a result, the IRS  now matches tax deductions for alimony payments by one former spouse with the taxable alimony income reported by the other.

High-Risk Tax Audit Areas - Automobile Logs
One of the biggest and most commonly audited items by the IRS for individuals in their own business, and employees of companies who use their car in business, is the tax deduction for business transportation. It is important that you keep good records of all tax deductible automobile expenses and a mileage log showing business miles driven.

Also, try to keep a daily log of business mileage. Ideally, such log would show the date, beginning and ending odometer readings, the location, the business purpose, and the client. Such detail is hard for today's business person to keep, but it's important to have something in writing in case you're audited. At a minimum, make sure you write down the automobile's odometer reading at the beginning and the end of the tax year and have a daily record that you could go back to and use to reconstruct a claimed business mileage tax deduction on your tax return.

Self-defense pays off
You should take every tax deduction you're entitled to on your tax return, and you should not be frightened by the potential of an IRS tax audit. However, you must exercise common sense and weigh the risk you are taking by claiming or using certain tax deductions on your tax return with the reward that you receive in terms of tax savings.

Don't be frightened by the chance for an IRS tax audit since it is slight, but also don't randomly increase your chances for an IRS tax audit with items that have minimal tax benefit to you. Use your own judgment and common sense along with the advice of your tax professionals.

CPAs say the best way to avoid a tax audit is to file a complete and accurate tax return. Double check your math, and make sure you have used the correct IRS tax forms and IRS tax schedules. And if you think the IRS may question a large tax deduction or tax credit, attach an explanation to your tax return when you file it.