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Take heart, your chances of an IRS audit are slim. Sort of. Last year, less than one percent of the 198,905,847 tax payers who filed in 2008 were audited (1,581,394 total), but that number jumps to 8.4 percent if you made more than $1 million (32,496 audits) and 14.2 percent (10,207 total audits) if you were a corporation with more than $10 million in assets.
The IRS lists its criteria for triggering an audit, including information matching (whether your tax info such as w2’s and 1099 match what the IRS has on file), related examinations (friends/business contacts/tax preparer who are also being audited) and the closely guarded Discriminant Function Score formula, which assigns number values to certain items on the tax return. If the total score for all the values exceeds a minimum score set by the IRS, the computer will flag that return for review.
Aside from never taking a deduction or having your pay stub directly sent to the IRS, here are eight tips for avoiding that dreaded visit from the tax man:
Choose Your Accountant Wisely
Tax can be very complicated, even for experienced accountants (Top firms such as Deloitte Touché routinely report errors). Though the IRS has recently increased requirements on tax preparers, requiring Tax Preparer Identification Numbers and background checks, shady accountants still exist. The IRS provides guidance on choosing a qualified preparer; the key things to consider are if the preparer has ever been reported to the Better Business Bureau (call your local office) or the IRS Office of Professional Responsibility (email opr@irs.gov).
If a tax preparer promises to make deductions go away without a legitimate plan of action, that’s probably audit red flag city.
Pay Taxes on Forgiven Debt
If a credit card company, or other lender, agrees to reduce or forgive debt, you still need to include it on your tax return and pay the tax liability. Debts are not taxable income in cases where the taxpayer proves that his debts surpass his assets or when debts get discharged through bankruptcy (Chapter 7 or 11). There are also special rules where there is a short-sale on your principal residence.
Respect Your State Return
The IRS shares information with states, so if your company is audited at the state level and owes additional taxes, this may prompt an IRS audit or vice versa. If you file in more than one state, the apportionment factors will probably be scrutinized, or an audit could be likely if you didn’t file in the time required.
Incorporate
In the past year, the IRS has increased scrutiny for Sole Proprietors; statistics show that a Schedule C is 10 times more likely to be audited than if you were to incorporate your business and elect S Corporation status. Though electing S Corporation status is an excellent strategy to reduce liability, it isn’t the best strategy for all businesses. If electing S Corporation status isn’t the correct strategy for your company, practice organized accounting processes such as maintaining a business bank account and business credit card, to help document your transactions and not co-mingle your personal and business funds. Using a proper accounting system such as QuickBooks or Peachtree also helps.
Beware Form 5213
If you’ve turned your hobby into a business, you might be tempted to file this form (“Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit”), which, in effect, keeps the IRS from auditing you the first five years of the business (if you can show a profit in at least three of those years, the business isn’t considered a hobby and you can take losses on the other years). The irony is that you’re virtually guaranteed an audit after five years.
The better strategy is to run your hobby business like a business: keep proper books, send out invoices, properly record income, use best business practices for that industry and stay away from Form 5213.
Don’t Fear the Home Office Deduction
Many say that claiming the home office deduction will trigger an audit, but there is no statistically evidence proving that. However, improperly claiming the home office deduction – i.e., claiming too much of your home for the deduction – has a very good chance of triggering an examination. Generally claiming more than 25 percent will attract IRS scrutiny. The main rules for claiming this deduction is that the home office must be your principal place of business and used exclusively for business (i.e., can’t use the dining room only during the day or your employer can’t already have a dedicated office for you). Find more tips about claiming the home office deduction here.
Be Aware of Audit Red Flags
A number of years ago, the Government Accountability Office compiled statistics on the types of deductions sole proprietors take relative to the amount of their revenue. Taking more than the “average” may garner IRS attention, but there is no evidence to support this (other than the fact the IRS researched these statistics for some reason). If you are entitled to high deductions, there is no reason not to claim them. But you should be prepared to prove entitlement if the return is questioned, which leads to …
Don’t Fear an Audit; Be Prepared for an Audit
Audits happen, so don’t neglect deductions you rightfully deserve just to avoid an audit. Properly document your information, keep good records through your accounting system and the business debit and credit cards. Get a business bank account and business credit card to separate transactions from your personal accounts. Talk with your accountant about what records you should keep as well as what logs should be documented. And lastly, speak with your CPA about tax planning, so you know ahead of time what deductions you should qualify for and how to substantiate those deductions. Because as the saying goes, A stitch in time saves nine. Or a nasty audit in this case.
For more information on tax preparation or audit preparedness, please contact Wendroff & Associates, LLC at 703-553-1099. Also, please look out for our upcoming Asset Protection for Families seminar this March. For more information, please click here.
