This is article written by Wendy Connick offers great tips for reducing the risk of a tax audit.
Do you cringe at the mere thought of an IRS audit? Consider taking a few precautions to give your tax return better odds in the audit lottery.
Due in large part to budget and personnel cuts, the IRS is auditing fewer and fewer taxpayers every year. On the other hand, since the primary goal of a tax audit is to make money for the federal government, auditors do their best to select taxpayers who they think are likely to owe the largest amounts in unpaid taxes. That means that if you lose the “audit lottery,” it’s probably because the IRS believes it can wring a whole lot of money out of you.
That said, no one is immune to an audit. Fortunately, there are some specific steps you can take to make your return less interesting to auditors.
1. Report all your income
It might be tempting to leave out a little income here and there when you’re filling out your tax return, but resist that urge. Even a small amount of income may be reported to the IRS by the person or company that paid you. If the IRS identifies a payment to you that you didn’t report as income, then agency’s interest in auditing you will go way up.
2. Keep your ratio of deductions to income low
One thing that’s guaranteed to pique an IRS auditor’s interest is a high ratio of deductions to income. Auditors reason that if you’ve claimed such an enormous amount of deductions relative to your income, then there will likely be many tax breaks they can invalidate in an audit — thereby creating a fat tax bill for you. Taxpayers typically deduct well less than half of their income, so if you cross that threshold, then you may draw an auditor’s attention.
If you actually can deduct more than half of your income, then you’ll have to decide whether you’re prepared to run the risk of an audit by claiming the full amount. No matter how high or low your deduction-to-income ratio is, make sure you have thorough documentation to back up every tax break you claim.
3. Use a professional tax-preparer
Working with a tax preparer. Professional tax-preparers, especially CPAs and Enrolled Agents, keep up to date on tax law and can be sure your return meets the latest requirements. And experienced tax-preparers are typically aware of what’s likely to catch an auditor’s eye; if you ask, they can take extra precautions to put together a tax return for you that seems less audit-worthy.
If you don’t feel you need a tax preparer, or if you can’t afford one, then at least use a quality tax software package to prepare your return. Tax preparation software dramatically reduces the odds that your return will contain errors.
4. Send in your return by mail, not electronically
In order to review the year’s tax returns for possible discrepancies, the IRS has to put them all into its computer system. If you file electronically, this happens automatically as soon as the IRS receives the file. However, if you file by mail, someone has to take the paper return and physically enter it into the database. And because the IRS is chronically short on personnel, many of those returns by mail never make it into the computer. Instead, they go to a warehouse for a few years and are eventually destroyed once the statute of limitations expires for that particular tax year. So if you send your return by mail, you have a good chance of never having the return entered in the audit lottery in the first place.
Note that you can still use tax software to prepare your return; you just need to print and mail it rather than e-file.
5. Be specific
The IRS is highly suspicious of perfectly round numbers on your tax return — like when someone claims exactly $5,000 in medical expenses. Don’t try to round expenses or deductions (even if you’re rounding down) except, of course, to the nearest dollar. And if you’re claiming business expenses, don’t put more than 10% or so in the “miscellaneous” category; try to pick a more precise expense category as often as possible.
6. Don’t be a sole proprietor
Business owners who are sole proprietors are far more likely to be audited than owners of other types of businesses (e.g., partnerships and corporations). This is especially true if your business is bringing in a relatively high annual income. According to Deduct It! Lower Your Small Business Taxes by Stephen Fishman, sole proprietors in the $100,000-$200,000 income range were audited at a rate of 2.4% in 2014 — significantly higher than all other forms of small businesses, even corporations in the $5 million-$10 million income range. Once your sole proprietorship starts bringing in more than $100,000 in annual revenue, seriously consider either incorporating or forming an LLC (this is a good idea from a legal and liability standpoint as well).
7. Don’t claim the Earned Income Tax Credit (EITC)
As a general rule, the higher your income, the more likely you are to be audited — except when it comes to the EITC. The IRS has seen such a high incidence of fraud related to this credit that it takes a very close look at anyone who claims it, even though taxpayers who claim the EITC typically have low income. Of course, the reason so many people fraudulently claim the EITC is because it’s such a darn good deal, so you’re better off taking the credit even if it might increase your chances of an audit. Just make sure your return is squeaky-clean, as it will probably be subject to extra scrutiny.
If you are eligible to claim this credit, then it’s even more important to seek professional help with your return. Tax preparers are required to go through a lengthy process to validate any claim for the EITC, including filling out a special worksheet to prove that they checked various aspects of your eligibility. So if you use a professional tax-preparer, the IRS is more likely to believe that you’re really eligible for the credit in the amount you claimed. Fortunately, there are programs such as VITA (Volunteer Income Tax Assistance) that will prepare your return for free if you fall under certain income requirements, which will generally be the case for EITC filers. At least that way you’ll get to have your taxes done for you on the IRS’ dime.