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. The High-Risk Tax Audit Areas
The odds are low that your tax return will be picked for an IRS audit. The IRS does not have sufficient personnel and resources to examine every tax return, so the IRS selects those tax returns which, upon preliminary inspection, have high audit potential -- those that are most likely to result in a substantial tax deficiency. In recent years, less than 2% of all individual income tax returns have been audited. However, your chances for an IRS audit are higher depending upon certain types of income, certain amounts of income, your profession, the types of transactions, and the types of tax deductions claimed on your tax return.
High-Risk Tax Audit Areas - High Wages
Generally, as your income increases, so does your chance of an IRS audit. 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 more than one and one half in 100. Your chances of being audited by the IRS are greater under the following circumstances:
· You have large amounts of itemized deductions on your tax return that exceed IRS targets.
· You claim tax shelter investment losses on your tax return.
· You have complex investment or business expenses on your tax return.
· You own or work in a business which receives cash and/or tips in the ordinary course of business.
· Your business expenses are large in relation to your income on your tax return.
· You have rental expenses on your tax return.
· A prior IRS audit resulted in a tax deficiency.
· You have complex tax transactions without explanations on your tax return.
· You are a shareholder or partner in an audited partnership or corporation.
· You claim large cash contributions to charities in relation to your income on your tax return.
· An informant has given information to the IRS.
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.
Overpaying Family Members: If a family member works for you, be sure that you pay them according to their actual responsibilities and experience and at a rate comparable to the rest of the job market.
Don't pay them more than they're worth just because they're family.
Income Boost: If your income for the current year is excessively higher than previous years, the IRS will
want to know why. The reason may be legitimate, like the fact that the demand for your business skyrocketed. But keep in mind that the IRS will then expect your return to show additional expenses in order to meet that increase in demand.
Extreme Expenses: If you have an itemized expense on your tax return that just doesn't match up with your income, the IRS will notice. For example, if you're claiming an income of $30,000 and itemizing a $5,000 desk for your home office... it's pretty obvious that something's not right and the IRS will want to follow-up
Write-offs: As every business owner knows, incorrect write-offs are one of the largest triggers for
an audit. If what you're writing off doesn't match what is expected of your business practices, the IRS will probably want an explanation.
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 call the IRS Freedom of Information Act Reading Room at (202) 622-5164, or write Box 795, Ben Franklin Station, Washington, DC 20044.
