Most tax payers, including myself, share the same dread of getting audited by the IRS, but in reality the chances of facing an IRS audit aren’t all that high. In fiscal year 2008, the IRS audited 1% of the more than 137 million returns filed the year before. For taxpayers making less than $200,000, the rate drops to 0.95%. Those with incomes greater than $200,000 though face an audit rate of 2.94%, and for those earning more than $1 million it jumped to 5.57%. Mind you the percent is higher for big money earners because there are much fewer people in these income brackets and it is much more cost-effective for the IRS to target these groups. After all, $1000 disallowed to a taxpayer in the 35% bracket generates $350 in additional tax, compared with only $100 from someone in the 10% bracket.
Types of IRS Audits
Despite what you see in the movies and read in the tabloid media most IRS audits do not involve men in black suits storming your home or office looking for receipts and hidden stashes of cash and other valuables. In fact most audits are “correspondence” audits where you get a letter from the IRS asking for more information. More than 1 million of the almost 1.4 million audits last year were correspondence audits, while only about 310,000 were actually field audits – those that involved face to face meetings.
IRS Audit Triggers
The IRS has a few different audit methods. First, every return filed is scored by its “discriminant function” system, or DIF, said Robert P. Brennan, a former IRS agent. The score is based on the IRS’s study of a sample set of thousands of returns. From that study, the IRS determines what is an average and valid range for, say, the amount of charitable-contribution deductions claimed by a person earning $100,000 a year. Then, a taxpayer with that income who claims a much higher deduction will get a high DIF score, and is thus likelier to get audited. That system only captures unusually high deductions; it can’t find someone who is under reporting income. So the IRS also organizes projects or focus areas, to examine certain types of businesses.
The IRS “is very concerned about the underground economy,” he said, adding that the IRS estimates about $290 billion in income goes unreported each year. As a result, in addition to high DIF scores, the tax agency focuses a keen eye on cash-based businesses, such as restaurants, gas stations and hair salons, Brennan said.
For small-business owners who receive Forms 1099, this is less of an issue, as the IRS can check what the taxpayer reports against the Form 1099 filed by the business that paid the money. In that situation, “the IRS has a record of all of your income earnings,” Brennan said. The project-based audits are focused “on the cash guy,” he said. “The cleaner who does your clothing, the guy who comes in to hang your lamp or do a back porch.
How to Avoid Getting Audited
Most non-automated IRS audits are based on people who take unexpected deductions based on their income or profession. Naturally the more deductions you have the less you pay in taxes and so the more likely the IRS is going to scrutinize your return. So by all means take your legitimate deductions, but keep your receipts so they you can substantiate the expense if you are ever audited.
I like to keep a large size yearly envelope (2009, 2010 etc) for my personal and business expenses receipts. Whenever I expense something I get a receipt and dump it in there. You should also keep copies of past year’s tax returns and associated documents (3 years is recommended). Incorrect numbers or math on a return are also red flags for triggering an audit. That’s why E-filing with tax software like Turbo tax is a way to cut down on math errors, since the tax software does the math for you and checks that your deductions make “sense” relative to the information in your return.
Here are some the key deductions the IRS looks at very closely:
Deduction for unreimbursed employee business expenses, such as meals and entertainment. “That’s always a popular form to audit,” Brennan said. “For a lot of people, that’s your classic bumping up of your expenses that you really don’t have,” he said. “When things are tough, people try to find as many deductions as they can,” he said. “I don’t tell my clients not to report this, I tell my clients be sure you can substantiate this.”
Home-office deduction. The IRS “is always interested in your office in the home,” Brennan said. “Not many people qualify for an office in the home, but many people claim it.”
Income from offshore accounts. The tax agency is “very interested this year in foreign bank accounts,” Brennan said. “They are trying to get foreign banks to disclose information of account holders. They will then take account-holder information, pull up that return and see if they disclosed it.”
Wage income, plus a Schedule C with a loss. “If a person is working full time and then [the IRS] sees a Schedule C with a loss” that may attract attention. “Some people have a vineyard or horse racing activity, they will seriously question that,” he said. “The IRS might say that’s a hobby.”
Carry-back of net operating losses. Business owners who carry-back a net operating loss may well find increased IRS scrutiny, Hechinger said. It’s likely, he said, the IRS may think “that because of the economy the way it is, people may be more aggressive. They want people to substantiate that loss carry-back,” he said. But “if it’s legitimate you’ve got to claim it.”
Capital-gain exclusion on home sale. Even with the downturn in the housing market, people who bought many years ago in pricey areas may find they still had a substantial gain when selling their home in 2008 or 2009. Any home improvements over the years would increase their basis in the home, and make it likelier that their gain falls within the capital-gains exclusion. But make sure you can substantiate the basis. You know you spent the money on improving that house, but unfortunately people toss records over time. You have to find ways to substantiate it.
If the IRS comes-a-calling
If the IRS sends you correspondence regarding your tax return never ignore the letter and answer it before the due date. The IRS won’t go away so don’t wait for a repeat notice. If you had taxes prepared by a firm or accountant, sit down and talk to them and have them forward the requested information to the IRS. If you did them yourself, make sure you provide the necessary information. A lot of tax software gives you the options of purchasing some kind of audit protection so take advantage of that if possible.
If this isn’t sufficient, you may be called in for a face-to-face audit. If that happens, consider hiring a professional like a CPA or a tax attorney to go with you. If you used a paid tax preparer, bring them along. Also make sure you prepare ahead of time to answer any questions.
How Far Back Can My Tax Returns be Audited? The Statute of limitations for an IRS Audit is broken up into 2 components. The time during which an action can be brought by the IRS for an audit and the time for IRS tax collection activities. Generally, there is a 3-year statute of limitations for the IRS auditing a tax return and a 10-year statute of limitations for the IRS collecting tax.