Avoiding Tax Audits: Tips on How to Avoid an IRS Audit
Everyone has heard the horror stories about IRS audits. It is a fact that audits are a hassle, even if your taxes have been done by the book and you have all the necessary documentation. For this reason it is a good idea to know the common reasons the IRS will audit so you can avoid one.
While sometimes audits cannot be avoided, many times they can. Being aware of how the IRS audit process works and what the common audit red flags are can significantly reduce your chances of an audit. It is important to realize the IRS mainly decides to audit people off of complex computer systems that perform statistical analysis on tax returns to determine if they have a high probability of being incorrect. Taking into account the IRS process and common audit red flags, below are some tips to avoid tax audits.
- Be Truthful: The easiest way to avoid an audit is to be 100% truthful in what you file, the IRS will likely catch on if you are not, their computers are more complex than most people realize. The IRS uses 3 different computer systems on each tax return to see if the information is accurate. The first computer system it runs the return through is the Discriminant Function System (DIF), which is a secret formula used by the IRS to rank returns on potential for error. The second computer system it runs through is the Unreported Income Discriminant Function System (UIDIF), which ranks the return for the potential of having unreported income. Third computer system it runs through is the Information Returns Processing System (IDF), which will compare the information you reported to the information provided by third parties to see if everything matches up. As you can see, the IRS has many checks and will find out if you are not truthful.
- Use a tax software program or tax professional to file: Using tax software or a tax professional can solve 3 of the most common reasons returns get audited. First being that it will ensure calculations are correct, second the return will be complete and third it will ensure it is legible. One of the most common reasons for tax returns to be audited is because there are math errors or they are incomplete. Using a tax filing program can ensure that the math is done properly and will ensure the return is complete before filing. If you decided to use a tax professional it is very likely that they will also use a tax software program that will ensure the accuracy of your filing as well.
- Be wary of filing a schedule C: People who file a schedule C are much more likely to be audited than people that don’t. This is because many individuals abuse the deductions they can take with a schedule C. It can be a good idea to consider forming an LLC or another type of entity to run these expenses through. When you own a business it is easier to hide these expenses and makes it harder for the government to see exactly what you are claiming and therefore will decrease your chances of receiving an audit.
- Be careful claiming home office deductions: If you are going to claim a home office be sure you can justify it. The IRS likes to look into this deduction quite a bit. If you do claim it make sure you keep a separate phone number to use for your business, keep an appointment book of clients that have visited your home office, use your home office address for billings rather than a PO box, and keep the square footage you claim for the business below 20% of your home.
- Electronically file your tax return: Filing electronically is the quickest and most efficient way to file your tax return. When you file electronically you will get a notification that your return was accepted and received by the IRS. The worst thing you can do is mail your tax return last second and not send it certified mail. It is important to have a confirmation that your tax return was received.
- Keep detailed financial records: It is very important to accurately report all income and expenses. It is a horrible feeling when you are filing your tax return and know you had quite a few expenses that you could deduct but don’t have the receipts to back it up and you just make a guesstimate as to what the expense was. Using estimates is a quick way to get an audit since the IRS computers are good at detecting what expense is likely for your business and if the expense is too low or two high, it could raise a red flag and trigger an audit
- File a joint return if you are married: Statistically, if you are married and you file separate, it is more likely that you will get audited. It is not that unusual for couples to file separately, but there are some problems that many couples run into that can be avoided by filing a joint tax return.
- Don’t use rounded numbers: Filing a tax return with rounded numbers makes the IRS think that you are not using actual numbers. It is very unlikely to have an investment return of exactly $10,000.00 and the IRS knows this. If you are using some estimates, don’t make them rounded numbers, this is a quick way to get your tax return flagged for an audit.
- Be sure to sign and file your return: You would be surprised how many people forget to sign the return or file it. If you don’t sign your return, this will just give your tax return more scrutiny and increase your chances of getting audited. If you don’t file your return, you can be hit with some serious fines once you realize that it hasn’t been filed
Being aware of the above items can help you better plan your next tax filing to ensure your risk of audit is decreased. If you are truthful, accurate, and keep good financial records your chances of being audited will be decreased quite a bit.