Strategies to Avoid the Dreaded Tax Audit

If you’re anything like me, you sometimes think about the possibility of a tax audit and wonder what you can do to make sure that never happens. Truthfully, tax audits are pretty rare, only about 1% actually ever get audited. They mostly occur with wealthy people (audited at 2.5%) and questionable returns with itemized deductions that may net the IRS some substantial amount of money.  There also audit some small number of totally random returns as well. Those that earn less than $200,000 (audited at about 0.7%) and file as individuals or joint earners stand the very least chance of an audit even though the numbers are increasing ever so slightly since 2008.

Strategies to Avoid the Dreaded Tax Audit

My Personal Experience with the IRS

I, myself, was audited about 15 years ago and of course I was in a panic mode when I received that letter in the mail. At first, I couldn’t figure out why I was selected, but I quickly realized that what was being questioned was something that my bank had done in error.

The situation was fairly straight forward. I had moved an IRA CD from one bank to another to get a better interest rate (back when they actually were paying interest!). In the process, the first bank had coded my transaction as a distribution instead of a transfer of funds as I had actually done. In creating that error, it resulted in me owing thousands of dollars of tax and penalties (I was under the age of 59½ for any IRA distribution so that triggered the penalties).

I called all parties involved and produced proof that the transaction of withdrawing my funds and the depositing them in a new CD had occurred all on the same day. After calling the IRS, they simply asked for that proof by mail and that would (and did) resolve my issue.

Strategies to Avoid the Dreaded Tax Audit

Here’s a list of common sense “must do’s” to avoid an audit for your 2015 returns:

  • Always be 100% honest on your return! The IRS gets copies of all your tax documents so if you leave anything out it will be found.
  • File all returns on time, especially if you are getting any refund. On the other hand, filing later when you owe reduces your chances of an audit (but file on time by the deadline, there are penalties even with an extension).
  • Double check all your math (or use a program that does it for you).
  • Provide complete information requested including all forms you need.
  • If claiming the Earned Income Credit, you increase the chances of an audit because this is an area ripe with potential fraud.
  • Keep accurate and separate logs of all your auto expenses for both personal and business use.

E-filing will reduce your chances of an audit even more than any other way.  Only about 0.5% are ever audited.

1040EZ forms are almost never audited.

Concerns for Business

For business returns, the record keeping can be even more complicated for you. If you are an entrepreneur or sole proprietor filing a schedule C for example, you are about 4 times more likely to be audited than other tax payers. Make sure you have all your records and documents ready and available as back up to any filed return.  Incorporating or creating an LLC can reduce your chances of a business audit and can also allow some increased tax deductions.

Cash businesses, like waitresses, bartenders and any “tip” oriented occupations, are also higher on the audit list.

For business returns:

  • Use a dedicated credit card and track its information.
  • Report all income.
  • Maintain accurate home office records.
  • Keep all records of travel expenses.

Red Flags

The IRS themselves will tell you there are several red flags that can trigger an audit of any return. Data entry errors are the biggest reason you will hear from the IRS. Generally if there’s a math error or a number that just doesn’t match up to the documents that the IRS receives directly from your employer, bank, or other agency, they will notify you of that error and ask for an explanation and correction where necessary. These “audits”, which are called correspondence audits, are done by mail. In those cases you can even respond by telephone and it can usually be resolved quickly and simply without the necessity for a lawyer or anyone representing you except yourself. The big thing is not to panic (like I did) and to respond timely to resolve it. In almost every case it will be taken care of easily.

Another error that that can trigger a red flag is under reporting of your income. It can happen easily if you try and speed through your return without getting all of your documents. By law, you must get all your documents mailed to you by January 31st. However, there are many times when your records are late or a corrected copy may be sent. If you think your documents are late, in error, or missing, check carefully before you file. Because the IRS has an automated match system for all documents, they will know immediately if you have under reported any W-2 and that will trigger an audit letter. Just remember, mistakes can be easily corrected but the IRS doesn’t know if it’s a mistake or a deliberate under reporting by anyone until they discuss your return with you.

Another flag is making itemized deductions that are atypical and very high when compared to the averages of all returns. By all means if you have high deductions that are legitimate, take them without worry if you can support them with documentation. Just keep in mind that you may have to explain them to the IRS if they are “unusually high” based upon you income.

Lastly, the areas of casualty losses, rental property losses, bad uncollectible debts, home office expenses, medical deductions and business travel, food and entertainment expenses can all trigger red flags and an audit. Make sure you can justify any of those kinds of deductions. Some people who are entitled to those deductions choose not to take them just to avoid increasing their audit risk, but if you have proper documentation, you shouldn’t have to worry.

 

The old scenario that you may think about from watching too many “B” movies of the IRS storming into your home or business with an audit team ready to rip through all of your records and files is something that just doesn’t happen to the typical taxpayer. If you are honest you really have nothing to worry about. If you make a mistake, which does happen, it can and will be fixed even if it does cost you some additional time and tax.

Once you have finished your return, it’s a good idea to look ahead to next year’s potential return and see if you can form a better, more thorough plan so that you do not owe or get any money next year. After all, as I have said many times, the best tax situation is to get your refund every week in your paycheck and with proper planning and a somewhat predictable earnings track, you can actually do just that!

Are you all set to file your 2015 tax return? Have you checked into e-filing? Have you filed already and received a refund? Do you have any problems that you may need advice on before you file? April’s tax due day, is less than five weeks away!

Image courtesy of Stuart Miles at freedigitalphotos.net (with changes)

8 Comments

  1. Our taxes are crazy complicated and I’m sure we’ll get audited one day. Not only do we have rental properties, but we have business and personal taxes and are an LLC taxed as an S-corp. I also write off some of my travel expenses, so that is always a red flag. Since I’m honest with our taxes and we aren’t too aggressive with our deductions, I don’t lose sleep over it.

  2. Ah yes, I remember those days when banks had high interest rates and I would chase them. Never had an IRA in a CD though. It seems from what I hear is that generally most people who get audited own their own business. I use tax software and it also tells you the chance of an audit and while that is not full proof, it still gives most people some peace of mind.

    1. Andrew, would you believe it if I told you that I once had a CD that paid over 16% interest? Of course, at that same time, the mortgage rates were over 12%. I agree that the business audits may be more likely than individual audits, but using an electronic filing method is a great idea to lessen your chances.

  3. Thanks for sharing these excellent tips, Gary. Being honest is most important. But your experience with the IRA CD is proof positive that it pays to keep good records. We already filed online for 2015 and received our federal return. We’re awaiting the state one now.

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