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HOW TO AVOID AN AUDIT
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HOW TO AVOID AN AUDIT
Although there is no foolproof method to guarantee you will never be audited, there are things you and your tax Preparer can do to avoid an examination:
Incorporate
If you are self-employed and file a Schedule C you automatically increase your audit chances. If you are self-employed the best way to avoid scrutiny from the IRS is to Incorporate or form a Limited Liability Company. Corporations and LLCs are audited far less frequently than individuals. It’s also a good idea to be incorporated to help protect your personal assets in the event of a lawsuit. Another benefit is the fact that corporations are allowed more deductions with fewer limitations, and officers of the corp. can borrow money as well as take a salary - the borrowed money being tax fee to the officer until converted into salary.
Please see information on how to INCORPORATE and form a LIMITED LIABILITY COMPANY.
Due to budget constraints there is a limit to the number of returns selected for examination. Most returns are selected by the end of the summer, so file on the last extension possible (October 15th). By then it’s likely that the IRS has already reached its yearly quota of audited returns so your chances of an audit is reduced.
Important: Remember that by extending the time to file your return doesn’t extend the time to pay any taxes you may owe. Taxes you owe should be paid by the 15th of April otherwise you’ll incur interest and penalty charges.
Although the IRS computer system flags returns that are potential audit targets, it is ultimately an agent who decides if your particular return will be sent to an examiner for a complete audit. Computers can’t read explanations, but people can. Add lots of information about why you are taking certain deductions and expenses. Use worksheets, spreadsheets and supplements to explain in detail any and all expenses and deductions that you feel may warrant an explanation. If your return is flagged for an audit by the computer system, the live agent that reviews your return may decide a complete audit would not be justified because of your detailed explanations.
Don’t Use Whole Numbers: Example: use $2,967 instead of $3,000.
Explain Inconsistencies: Explain all inconsistencies from one year to the next. Example: Name changes of yourself, spouse or dependents; Changes in amounts or types of deductions.
Avoid Disagreements: Make sure your State tax return agrees with your Federal return. If you make money in various states and file several state income tax returns explain this to the state agencies as well as the IRS.
Explain Income Changes: Explain differences in your income and/or expenses compared to prior years.
Answer All Questions: Leave no blanks.
Neat Returns: Either use a computerized tax preparation program or type the return. Don’t file a sloppy return.
Avoid "Misc." And "Other" Deductions: Categorize each expense. Most of these types of expenses are office expenses or operating costs of one sort or another. Large "Misc." and "Other" deductions may lead the IRS to believe you cannot prove the items.
The IRS uses a system to identity tax returns to examine. This system is called the DIF (Discriminate Income Function). The scoring system is set up to identify specific returns that, if audited, will generate additional income tax. The IRS is looking for more tax; they compare your return with other returns that have been audited in the past, which resulted in more income tax for them.
Other than IRS employees who are directly involved with the system, few know for sure the actual DIF ratios. However, I did a little research and found that by dividing expenses by income on a specific tax return schedule a ratio can be found that, if exceeded, may result in your tax return being flagged for an audit:
Those ratios are:
SCHEDULE A: If ratio exceeds .45 (or 45%) Probable Audit Flag
SCHEDULE C: If ratio exceeds .60 (or 60%) Probable Audit Flag
SCHEDULE F: If ratio exceeds .65 (or 65%) Probable Audit Flag
Increasing income or reducing expenses and deductions can reduce the ratios of the specific schedules on your tax return.
As noted above, the DIF is a computerized system based on ratios and information gathered by IRS examiners. The computer, based on the DIF scores, flags a return for possible audit. An agent will still review your return and decide if the examination should take place. Use this to your advantage by attaching detailed explanations of everything you claim on your return.
There is an economic realty that must be kept in mind when preparing a return. A certain amount of money is needed to support yourself and your family. Did you report enough adjusted gross income to cover normal and every day living expenses such as rent, food, and clothing? If not, the IRS will question the validity of the return simply because the numbers are not realistically possible.
Electronic Filing: Although this has not been confirmed, only 40% of the information is manually entered into the computer when the Return is mailed in to the IRS. When electronically filed ALL information is entered which may be used to determine your DIF score.
Amendments: If possible, try to avoid amendments. The filing of an amended tax return may attract IRS attention and subsequent scrutiny. An amendment can possibly open you up to an examination of both the amended return and the original return. However, as above, if you use detailed explanations the agent may decide the audit is not worth the trouble.
Bad Debt Expense: Often questioned.
Casualty Losses: Often Questioned.
Medical Expenses: Remember the Adjusted Gross Income Limit.
Charitable Contributions: Understand the limitations and what constitutes as a legitimate donation.
Home Office: An old IRS favorite. Discuss with your Tax Preparer or Accountant the advantages and disadvantages of taking the Home Office expense and whether or not it is worth the audit risk.
Numbers Don’t Match: This refers to the information reported to the IRS compared to what you report on your return. People who pay you money (whether as an employee or Independent Contractor) will report your income to the IRS. This information is sent to the IRS and entered in the computer under your Social Security number and/or Employer Identification Number. If your return shows less income than what has been reported to the IRS it may trigger an audit. At the very least they will send you a letter asking for an explanation or access you additional tax on the difference.
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