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Audits - To Know One is to Avoid One

The best way to handle a tax audit from Uncle Sam is to avoid one from the start.  This article will arm you with information about actions that raise red flags with the IRS and ways you can sidestep those pitfalls.

Written Feb 10, 2008, read 6305 times since then.
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The best way to handle a tax audit from Uncle Sam is to avoid one from the start. Regardless of whether you win a battle with the IRS, audits are stressful, time consuming, and a waste of good business time. With audit rates on the rise, it is worth taking a few moments to learn how best to avoid them. Based on our experience, we provide you with some key ways to reduce your chances of receiving an audit from the IRS.

HIGH RISK AREAS

Upper Incomes

In March of 2005 former IRS Commissioner Charles O. Rossotti was quoted in the New York Times as saying, "The fact is, people who make more than $100,000 pay more than 60% of the taxes, and we need to focus there."  One hundred dollars disallowed to a taxpayer in the 35% bracket generates $35 in additional tax as opposed to only $10 in additional tax generated by someone in the 10% bracket.

Over the past several years, the IRS has been redeploying their resources to focus more heavily on business owners, those with investments and partnerships, and those in high-income brackets. 

If you make more than $100,000 a year, your risk and probability of an audit has increased. This means that it has become more important than ever to keep adequate records that substantiate your deductions.

Unreported Income

Unreported taxable income is a common red flag. The IRS discovers unreported taxable income when the taxable income you report on your tax return does not match with information gathered from banks and others. For example, if you failed to report interest earned on your bank savings account, the IRS will typically catch this error when it matches the bank's interest payment records, called 1099 forms, against your tax return. Make sure you have 1099's, etc. from mutual funds, banks and other sources.

Self-Employed and Cash Incomes

Because past audit evidence has proved that 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 on a company’s payroll.  The same holds true for individuals who traditionally receive payment in cash

(i.e., taxicab drivers, waiters and waitresses). At times the IRS will conduct tests to ascertain whether the taxable income reported by an individual is adequate to support his or her lifestyle.

Lifestyle

Unless you are prepared to defend them, don't take tax deductions that may be questionable. The key words are "reasonable and relative" in relation to income. If you earn $165,000 and claim $125,000 in deductions; or live in Beverly Hills, and report only $30,000 income, don't be surprised if the IRS requests a meeting.

Mileage Logs

Tax deductions for business transportation are some of the IRS's favorite items to audit. This applies to individuals with their own businesses, as well as company employees who use their car, or vehicle, for work. For all business transportation deductions it is important to keep good records of all tax deductible automobile expenses and a detailed mileage log showing business miles driven. 

If applicable, mileage logs should be kept on a daily basis, and show the date, beginning and ending odometer readings, the location, business purpose and customer name. While such detail may seem overly demanding for someone with a busy schedule, such detail will be essential in the event you are audited. We encourage our clients to use their PDAs and Outlook calendars to record their mileage. Others, have purchased electronic automobile products with features for maintaining this information, and have, as a result, found the record-keeping task far less onerous.

Your Business Expenses must be Business Expenses

Avoid schemes that claim you can convert personal expenses into allowable business expenses just by labeling them as business expenses. If you are "in business," and have a "profit objective" you can substantiate, then the conversion potential is legal. But, you really have to be "in business."

Home Offices

Home office tax deductions are scrutinized by the IRS. Since the tax rules for deducting home office expenses on your tax return are complicated, make sure you qualify for these deductions. By claiming the home office deduction, you increase your chances for an IRS audit. If, however, you are clearly entitled to claim these deductions, you should take them, but only if they are substantial enough to make a tax difference. If the tax savings will be minimal, it is best to avoid claiming home office tax deductions.

Schemes

Be skeptical of secret vehicles or structures that can insulate your income from tax. Time and time again U.S courts have rejected such claims. Just by making frivolous return arguments in tax court, you could be hit with a penalty of as much as $25,000.

STRATEGY CONSIDERATIONS

IRS DIF Score

When your tax return is filed, the IRS computers compare it against what is known as a “differential” score, or the national Discriminate Information Function (DIF) system average. They calculate the DIF score by using a closely-guarded formula. Initially, the business activity code that you fall under is determined. Your tax return will be compared to the national averages from this group. Each line on your return is assigned a score that is then compared to the averages from your peer group. Tax returns with the highest DIF scores represent returns with the highest probability rates of inaccuracy, and are therefore, scrutinized by experienced IRS examining officers who determine which tax returns will provide the best chance for collecting additional taxes, interest, and penalties.

IRS Audit Calendar

In July of each year the IRS assigns its work loads and work force to the zip codes with the highest DIF scores. (The IRS groups tax returns by zip code and then determines which areas have the highest DIF averages.) Half of all audits are selected randomly, while the other half is based on these scores. 

If you have reason to believe your tax return is at high risk for being audited, you have two tactics to consider: (1) Moving to a zip code with low DIF score averages, or (2) Filing after July 1st, which will eliminate your chance of being included in the IRS's random selection. Neither precaution is a guarantee that you will avoid an audit, but if you follow through with one or the other, you could significantly reduce your chances of an audit.

Audits are indeed unpleasant and can even be costly. While large deductions can trigger an audit, you have the right to take all legitimate deductions. Provided you have taken only those deductions for which you are eligible and have kept documentation substantiating these deductions, it is likely that you will be able to adequately answer all IRS auditing questions.

Accounting, Taxes, Business Consulting 
Seattle, Washington 
Elizabeth Mance

Elizabeth Mance is the owner and manager of Accountability Services, a full-service local accounting, tax and consulting firm that caters to family and privately owned companies. The firm was founded in 1997 in Seattle, WA.

Learn more about the author, Elizabeth Mance.

Comment on this article

  • Freelance journalist + author of "My So-Called Freelance Life" and "The Anti 9-to-5 Guide" 
Seattle, Washington 
Michelle Goodman
    Posted by Michelle Goodman, Seattle, Washington | Feb 11, 2008

    Elizabeth, great info. I can see I need to keep a driving log! And I laughed at my real estate agent... ;)

  • Social Media advisor, Twitter queen, marketing 
Edmonds, Washington 
Karen Rosenzweig
    Posted by Karen Rosenzweig, Edmonds, Washington | Feb 14, 2008

    Wow, great info! Thanks so much for sharing. I recently went through a Wash Dept of Revenue audit and it wasn't fun...good record-keeping is crucial!

  • Seattle Realtor 
Seattle, Washington 
Phil Greely
    Posted by Phil Greely, Seattle, Washington | Sep 28, 2008

    Good article...I think I only know the surface of what I can deduct. As far as mileage records go...I've heard a person only has to record for 3 months out of the year and then can average it out for the remaining 3qtrs. Is this true? It would also make recording less of a burden as I could know that I'm done in April!!

  • CPA, MBA, Wealth Strategist 
Tacoma, Washington 
Merry McNutt
    Posted by Merry McNutt, Tacoma, Washington | Jan 16, 2009

    Very nice article, Elizabeth. Wanted to reply to Phil's comments about recording deductions for 3 months and then average it out. No, don't do it. That is not true. You must be able to prove all deductions down to the last penny if you are audited. I just met with a client and IRS agent today. These clients are my most thorough paper trail/ record keeping clients and it was still a huge pain. Keep every record for at least three years after the return has been filed.

  • QuickBooks Training & Help, Quicken Classes (PC/Mac), POS, Problems Solved, Training, Set up, Consulting, 1on1, In-Person, Tutoring, Instruction, Private Lessons, Seminars, Classes & Financial Records Check Up & Bookkeeping & Accounting Consultation 
Seattle, Washington 
Keith  Gormezano
    Posted by Keith Gormezano, Seattle, Washington | Jul 30, 2009

    I am constantly giving some of my QuickBooks set up, review, and training clients when I come to their place of business this same reminder about the need to support their deductions.

    The major areas of concern are in the automotive (yes, going to a Biznik event qualifies) as well as the meals and entertainment category (ditto and don't forget the tip you left for the barista for letting them meet your client at their coffee shop.)

    The funny thing is when I quizzed one client about their spending over a month's time, we discovered that they had omitted several hundred dollars worth of deductions by not writing them down which were offset by a hundred dollars of deductions they couldn't substaniate.

    So another reason for record keeping is to not over pay one's federal income taxes and self employment taxes if applicable.

    Unless you prefer to, smile.

  • CPA, Accountant 
Irvine, California 
Shaun Lawrence
    Posted by Shaun Lawrence, Irvine, California | Sep 26, 2009

    Good article. Documentation is important and knowing the red flags helps. Unless you alarm them with a red flag, chances of an audit are rather low. I do bookkeeping and I also encourage my Irvine bookkeeping clients to verify some of the big, odd expenses.

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