One of the biggest fears people have is receiving an audit notice from the IRS-it ranks right up there with being diagnosed with a life-threatening illness.
One of the biggest fears people have is receiving an audit notice from the IRS—it ranks right up there with being diagnosed with a life-threatening illness. Of course, the IRS does nothing to alleviate this fear, because the more frightened you are, the less likely you will be to cheat on your taxes.
The IRS audited one out of every 104 tax returns in federal fiscal year 2013. It’s becoming increasingly evident that the greater your total income, the more you’ll attract the agency’s attention. Last year, the IRS audited about 10.85% of taxpayers with income greater than $1 million. The audit rate dropped to 0.88% for those with income less than $200,000.
Some of the audits were taxpayers pulled at random. The rest of the returns are selected for examination in a variety of ways.
Here are 5 things on tax returns that catch the attention of the IRS and ways you can minimize your chances of being audited.
1. Large itemized deductions
The IRS has established ranges for the amount of itemized deductions based on a taxpayer’s income. Deductions that exceed the statistical “norm” for a given state and region may be red-flagged for a closer look.
This does not mean that you shouldn’t take legitimate deductions. Your deductions could exceed the IRS range due to high medical expenses and large charitable contributions. Take all valid tax deductions—just be sure you keep your backup documentation.
2. Self-employment income
The IRS believes that the vast amount of underreported income occurs among the self-employed. Self-employed taxpayers are audited by the IRS far more frequently than those who receive a W-2 for wages.
People who are employed by others and receive W-2 income but also run a business that reports a loss are especially high on the IRS radar screen. You will need to be able to prove you are operating a business with the intention of earning a profit and not just trying to write off the expenses of a hobby.
You will need to be able to pass both the “passive loss” and “hobby loss” rules in order for the deductions to stick.
3. Business expenses
Big deductions for business meals, travel, and entertainment are always ripe for audit. A large write-off will raise red flags if the amount seems too high for the business. The IRS looks for personal meals or claims that don’t satisfy the strict substantiation requirements.
Taxpayers claiming 100% business use of a vehicle is also a huge red flag. The IRS knows it’s extremely rare for an individual to use a vehicle strictly for business.
4. Rental properties
The IRS is scrutinizing rental real estate losses for those who claim to be real estate professionals. You must meet two requirements:
1. More than half of the personal services are performed in real property trades or businesses in which you materially participate.
2. You perform more than 750 hours of services in real property trades or businesses in which you materially participate.
5. Home offices
Taxpayers who operate a business from their home are entitled to deduct the portion of their home that is dedicated to operating the business. The IRS believes that many taxpayers use this deduction as a means of writing off personal expenses and it carefully scrutinizes tax returns that claim the home office deduction. Claiming this deduction greatly increases the chances that your tax return will be audited.
You should consult a tax expert to determine if you are entitled to claim this deduction. If the tax savings are minimal you may opt not to claim the deduction simply to avoid the scrutiny. For details, see IRS Publication 587.
What to do in an audit
There is no way to completely audit-proof your return, and if you do get an audit notice from the IRS, don’t take it personally. It does not mean the IRS believes your return is fraudulent. When you get a notice, pick up a copy of IRS Publication 1 “Your Rights as a Taxpayer.” Be courteous and helpful without volunteering more information than what is requested. Plan ahead so that you are organized and can answer questions promptly. Ask for a postponement if you need more time to prepare.
If you are a self-employed taxpayer or have unusual circumstances that place your return outside of the statistical norm, let a professional prepare the return. Self-prepared returns also are more likely to be audited. The IRS believes that a non-professional has limited knowledge of the 4,000 pages of tax code.
Tax law is complex. The fee charged by an Enrolled Agent or CPA can be easily justified by the peace of mind they bring if you get the dreaded audit notice.
Rick Rodgers, CFP, is president of Rodgers & Associates, “The Retirement Specialists,” in Lancaster, PA, and author of The New Three-Legged Stool: A Tax Efficient Approach to Retirement Planning. He’s a Certified Retirement Counselor and member of the National Association of Personal Financial Advisers. Rodgers has been featured on national radio and TV shows, including “FOX Business News” and “The 700 Club,” and is available to speak at conferences and corporate events (www.RodgersSpeaks.com).