One of the things our society fears most is the tax audit. Almost no one thinks that a tax audit would be fun. The good news is that the IRS only audits a little more than 1% of tax returns each year. Some of the audits are purely random — luck of the draw. There is no way to avoid a random tax audit. However, some audits are the result of tax returns that have raised red flags. If you want to avoid drawing closer scrutiny, there are some things that you can do.
Avoiding IRS Red Flags
One of the best things you can do to avoid an IRS tax audit is to check your tax return for errors. Errors in your math calculations can result in an audit — especially if the error is in your favor. Additionally, if you fill out your forms incorrectly, you might be red-flagged for an audit. And, there are still plenty of people who fill out their tax forms by hand. If your forms are sloppy or illegible, you could find yourself facing a tax audit. Here are a few more red flags that might initiate a tax audit:
Home Office Tax Deduction: The IRS is very clear on deductions for the business use of your home. You can only take a home office tax deduction if the space is used just for your business. In my old home, my “office” was also used for storage. So, instead of using the whole room for a deduction, I could only deduct the 6 x 3 area that encompassed my desk and printer stand. Taking the home office tax deduction can be a red flag, since the IRS will want to look in whether you should really be taking that deduction.
Big Tax Deductions: Thanks to data compiled over decades of tax returns, the IRS has a pretty good idea of the average amount of deductions taken by people in different income brackets. If you seem to be claiming more charitable deductions, and other deductions, than others at your income level, the IRS might red flag your tax return. Make sure you have all the documentation to back up your donations.
Cash: Cash businesses, and large cash transactions, are also likely to mean scrutiny for your tax return. One thing you should realize is that cash transactions over more than $10,000 have to be reported by casinos, banks, and others. This means that if you fudge on these numbers, the IRS could find you out. Businesses that operate using cash are also likely to be red-flagged for an audit. The IRS feels like cash businesses could be more likely to under-report their income.
Mismatch with 1099s: Even if you don’t get a 1099 from someone you did work for doesn’t mean it won’t get sent to the IRS. Computers compare what comes in with what you report. If what you report is less than what your 1099s and W-2s say, you are likely to be audited. Understand, too, that starting this year, in 2011, PayPal and similar businesses will be required to report transactions on the 1099-k form. So keep good records.
If you are doing everything correctly, and you have the documents to back up your claims of credits, deductions, and income, then there isn’t much to fear from a tax audit.