The mere thought of an IRS audit strikes fear into the hearts of the brave and courageous. Taxpayers have reason to fear the IRS inquisition; audits are designed to make believers out of the heathen. The feds have enormous clout and are ready to use it if they think you have been fudging.
Understanding the system can help you dodge the audit bullet.
An IRS audit is not a notice. The IRS service centers generate millions of notices every year telling taxpayers they have overlooked reporting of some item of income on their return, or other adjustment. The notice will recalculate the tax due and ask for payment or occasionally inform you of a refund.
An IRS audit letter will demand you to come into the IRS office or worse yet, inform you of a scheduled visit by an IRS auditor at your place of business.
The IRS does not audit a large percentage of tax returns. They don’t have to. They have vast databases of information to identify their targets. You are at a disadvantage dealing with them they know all about you and you shouldn’t count on the IRS missing anything.
Audits are normally not blind fishing expeditions; the audit letter will contain a list of items the IRS wants to look at. Frequent items of interest to the IRS are travel and entertainment, auto expense, meals, miscellaneous expenses, underreported income and repairs. Auditors are equipped with an industry specific checklist. These lists include likely tax problem areas in your line of business and items to be reviewed.
The auditor has some discretion to examine other items that arise during the audit if they suggest problems.
The best way to deal with audits is to avoid them. You should approach the federal tax system and the preparation of an income tax return the following assumptions clearly in front of you:
1: Don’t count on hiding anything. If you did anything financial and left a paper trail the IRS will know about it. If you have an expensive boat, they will ask how you paid for it. They check with all third parties, auto registrations, property records, bank records they will know about any records you have with them. If you applied for a mortgage and fudged a little on income, to make yourself look better you will be asked to explain why your income on your tax return is not the same as income on the mortgage application.
2: They have a pretty good idea of what it costs you to live. That is how much you should be spending for groceries, transportation and other items of a normal household. Combined with mortgage and other loan information, what you have reported along with deductions you have taken the feds can arrive at a fairly comprehensive household budget. If you fall very far outside the averages your story had better make sense. If you live in an apartment it might be a tough sell to tell them you don’t buy much food because you eat out of your garden. If there is not enough reported income to support your lifestyle you will be asked how you are maintaining it on your income. This is how Al Capone found himself on the way to prison.
3: They know what the average deductions should be for your income range. These numbers are published on the internet and you can look them up. If your deductions exceed the average by a certain percentage and the exact percentage is a secret, they add points to you DIF score. A high enough DIF score and your return will get reviewed for possible audit. Experience tells us exceeding the averages by around 15% is about the magic number to increase the odds of an audit. Normally an agent does not know why a return has been pulled for review, although they have the list of what they should be looking for on that return.
4: Stay off of round numbers. Round numbers on your return are a flag; it tells the IRS you are using estimates and not keeping careful records. Mileage and meals are two high target areas, because this is often where something is hidden. Maybe you didn’t go 12,000 business miles during the year maybe it was 11,917. Meal expense of $3,000 may be about right but $2,983 looks like you are a better record keeper.
5: Missing income. This is a killer. Making a mistake on deductions is one thing but forgetting to put down income can be a ticket to court. Generally if it is detected you are underreporting your income the auditor starts assuming you are pulling something and they will no longer give you the benefit of any doubt.
There is no way to guarantee avoidance of an audit, the selection process is a carefully guarded government secret, but a heads up on the above points and careful documentation in troublesome areas avoids a lot of grief.
John Murray is a CPA in Minnesota with over thirty years experience in the area of tax. He has represented numerous taxpayers in IRS audits. Author of many tax articles. Taught accounting at community college, author of Lake Superior Wow! 99 fun things to do in Duluth and along the North Shore, Marlor Press 1993; website http://www.JohnMurrayCPA.com
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