How to Avoid Being Audited by the IRS

Perhaps one of the most identifiable actions of the IRS is their right to review and audit a personal or business tax return. Understandably so, this process is oftentimes looked to as being both burdensome and apprehensive. When an individual is scrutinized under the watchful eye of the IRS, certain amounts of trepidation may set in. However, the representation of an austere, starched-collar examiner sitting across from you in a sterile, harshly-lit room is far from the reality.

In fact, the chances that one's tax return will be selected or pulled for an audit are very slim. In 2008, the number of IRS audits performed during the calendar year actually fell for the first time in a decade. In large part, this was due to IRS personnel being reassigned to assist with both the distribution of the Government's Economic Stimulus Rebate program, and being called upon to assist with FEMA disaster relief.

In 2008, those individuals who submitted returns with gross income of $200,000 or less had only about a one percent chance of being audited. Returns over the $200,000 benchmark were audited only about three percent of the time. About one out of twenty returns with gross income that exceeded one million were chosen for audit. On the business front, in 2008 the overall number of audits rose slightly for some businesses, and saw a fall for others. More emphasis was placed on medium and large corporations, as audit rates saw a slight increase for those companies with more than $50 million in assets and dropped slightly for those with less than $50 million in assets.

The majority of audits are done via correspondence. The IRS generally has three years from the date a return is filed and assessed to perform this type of audit. The bulk of actions taken under this type of an audit are done systemically, and if one's return is pulled under these provisions, it does NOT suggest that the error made was intentional or dishonest in nature.

Returns are subject to an income document matching program. Simply stated, the IRS checks the income documents (such as W2s and 1099s) that are included and reported on one's return with the same documents that are sent to the IRS or to the Social Security Administration by employers, banks, casinos, brokerages, and others. If an amount has been underreported, or is not reported, a letter is generated that proposes the tax increase, along with any appropriate penalties or interest. If the amount that was not reported is egregious, an additional understatement penalty may apply.

For this reason, the IRS encourages one to keep neat and orderly tax records, and to be thorough is reporting all income sources in a timely manner. Well-organized tax records not only assist in the preparation of a true and accurate return, but also assist in easily resolving potential audit selections. Tax records should be kept for a minimum of three years, but certain records that may have implications beyond the three-year window, such as documents relating to a home purchase or sale, stock transactions, and IRA distributions and contributions, should be kept longer. Employers should keep employment tax records for at least four years after the tax becomes due or is paid, whichever is later.

Other returns are selected by computerized screening or by random sample. The IRS may select a return for examination based on scoring done by a program called the Discriminant Inventory Function System. (DIFS)

The DIFS assigns a numeric score to each return after it is processed, and certain higher scores are then chosen for additional review. A fallacy that many individuals misunderstand is the idea that once the IRS has audited you, you are "red flagged" or put into a pool of potentially high audit filers. Returns selected under the above programs are not subject to this type of ongoing analysis. If you are required to undergo what's called a desk audit or a field audit, and you have been found liable for intentional underreporting or for deliberately making an overage on expenses, then future returns may likely be pulled. Additionally, if certain expenses or credits are disallowed, there may be additional steps one must take before they are again allowed on a subsequent return. The Earned Income Credit is one such credit.

In general, there are a number of steps one can take to avoid being audited by the IRS. A straight wage earner's return where an individual opts for a standard deduction has little to no chance of being selected. However, when additional schedules are filed that allow taxpayers to take various deductions, those odds increase. A Schedule A, Itemized Deductions, and a Schedule C, Profit or Loss from Business, are two such forms that permit a variety of expenses that reduce one's taxable income. Be sure ALL expenses being claimed are allowable, reasonable, and sufficiently explained where need be. Extremely high charitable deductions, inflated self-employment automobile usage deductions, and large business deductions that are simply listed as "Other Expenses" on the Schedule C are all notorious for further review.

Other potential problem areas to thoroughly review or to avoid are claiming tax shelter investment losses, complex investment or business expenses, or engaging in a large amount of cash transactions. Banks and lending institutions are required to report any counter cash transaction over $10,000. This is reported to the IRS and creates a paper trail for potential review of an individual's assets.

If one reports all of their income, and takes all deductions that they are entitled too, the odds of being selected for an audit are minimal. Knowing that the possibility of an audit increases with certain income levels and taking deductions on certain items, one must be sure to prepare taxes accurately and completely, and maintain good records to assist the IRS in validating any discrepancies.

The IRS offers the following publications to assist you with the above:

* Publication 5: Appeal Rights and How to Prepare a Protest if You Don't Agree

* Publication 552: Recordkeeping for Individuals

* Publication 556: Examination of Returns, Appeal Rights, and Claims for Refund

* Publication 583: Starting a Business and Keeping Records