What IRS agents look for

February 3, 2006

The only thing more taxing than April 15th is getting a letter from the IRS. Here's how to help ensure you'll never receive one.

Uncle Sam may want you, but the IRS wants your money, and it's leaving no stone unturned in its efforts to make sure it gets every cent it's entitled to. The number of audits of individuals with incomes over $100,000 jumped 40 percent in fiscal 2004 and surpassed 221,000 in fiscal 2005, the highest figure in 10 years. Even so, the IRS announced that the number's "still too low."

Small business audits have increased as well-17,867 completed in 2005 vs 7,294 just a year earlier-and the IRS intends to audit 5,000 more S corporations. To aid the agency in its crackdown on tax dodgers, Congress recently approved a $10.7 billion IRS budget, with an increase specifically earmarked for collection, or "enforcement," activities.

So what's a taxpayer to do? No one can be completely audit-proof. After all, you're not going to change professions or reduce your income just to fly under the IRS' radar screen.

Separate business losses from personal ones

Is your side business really just a hobby in corporate clothing? Nearing retirement, a cardiologist from Philadelphia sold a bunch of gold and silver coins and declared a business loss on his tax return. "He collected coins as a hobby, not as a business venture," says certified financial planner Steven W. Kaye of American Economic Planning Group in Watchung, NJ, "so the business loss was disallowed."

Another taxpayer owned a boat and rented it out occasionally, incurring losses that he offset against his income. "He owned the boat primarily because he enjoyed it," explains former IRS special agent and tax attorney Julian Block of Larchmont, NY. He recalls a tax court ruling in which the judge noted, "A 'business' will not be turned into a 'hobby' merely because the owner finds it pleasurable; suffering has never been made a prerequisite for deductibility."

The IRS computers look for certain telltale signs that a taxpayer may be trying to pass off a hobby as a business. So think twice before filing a return with a Schedule C, "Profit or Loss from Business," that reports a net loss from a small business venture, says Frederick W. Daily, tax attorney and author of Stand Up to the IRS (Nolo, 2005). "IRS auditors go after these returns like bees to honey."

Take-home: Don't mix work and play. Determine whether the venture's a business or a hobby by asking yourself objectively and honestly whether you entered into the activity for the purpose of making a profit. If the answer's No, then just because the venture throws off losses doesn't turn it into a business.

What-and what not-to deduct when it comes to travel

"This is probably the biggest hot spot when it comes to audit minefields," says Kaye. "The IRS targets sole proprietors and small businesses where the amount or the ratio of the deduction is way above the norm for a particular field or income bracket. A ratio that's much greater than the norm is like low-hanging fruit just waiting to be plucked."