No one looks forward to a tax audit, but the information in this article can help you be prepared if you do find yourself in that unpleasant situation.
There are two pieces of advice that you should keep in mind about audits:
- If you've done your homework, kept good records, and your return is truthful, you don't have anything to worry about.
- It's better not to be audited.
Let's talk about the second point, first.
The average taxpayer has a very small chance of being audited. The IRS does not provide details on its audit criteria - in fact, they are a closely guarded secret.
However, if you are self-employed, the odds are that your return is not typical of the millions of returns filed by employees. This alone is likely to increase your audit risk.
IRS targets Schedules A, C, or E
The IRS is attempting to increase revenue collection by closely scrutinizing tax individual tax returns that are most likely to contain errors. And, it defines those types of returns based on the Schedules filed to claim deductions. These targeted forms are the very ones most likely to be filed by a small business owner: Schedule A (Itemized Expenses), Schedule C (Business Expenses) and Schedule E (Supplemental Income).
Warning
The IRS is not only looking more attentively at those forms, it is also closely monitoring tax professions who prepare large numbers of those forms. While the IRS doesn't require that your preparer audit your books or verify every detail, he or she can not ignore the implications of information that you furnish to him or her.
Your preparer is required to make reasonable inquiries whenever information that you provide appears to be incorrect, inconsistent with an important fact or assumption, or incomplete. Additionally, your preparer is obligated to make appropriate inquiries to determine the existence of facts and circumstances required as a condition for claiming a deduction or credit.
Be aware of the hot buttons on returns.
When the IRS evaluates a return, the staff members zero on on certain deductions. These are the items that are going to be examined more closely. Make sure you have the documentation to support each one that you claim.
- Targeted items on Schedule A (Itemized Deductions) are
- Unreimbursed Employee Business Expenses claimed on Form 2106.
- Mileage claimed on Form 2106.
- Travel, meals and entertainment expense.
- Charitable contributions.
- The most common issues on Schedule C (Business Expenses) are:
- Gross receipts not being fully reported.
- Ordinary and necessary test and business purpose test met for all business expenses claimed.
- Expenses deducted in correct year.
- Schedule E (Supplemental Income) items mostly likely to pique the IRS's curiosity are:
- Rental income and expenses not being properly reported.
- Rental depreciation not being correctly calculated.
- Deduction limitations such as those related to passive activity losses, the at-risk rules and basis computations, correctly applied.
Protect yourself. Know the rules for claiming the deductions and don't try to game the system. Make sure you have the documentation required by the rules, well-organized and easily accessible if you are audited.
Careful recordkeeping and return preparation minimizes risk
While there is no guarantee that your return won't be randomly selected for audit, careful compliance with the tax code can minimize the risk you will be singled out because of issues with your return.
Make sure that the information provided on any W-2 forms you receive from employers, and 1099s or 1098s you receive as an independent contractor or from banks, mutual funds, brokerages, retirement plans, or any other source, are accurately reflected on your return.
If there is a mistake, get the issuer of the form to correct it. The IRS computer matches these figures with the figures on your return, and it will question any mismatch. If you have many of these forms, report each one separately somewhere on your tax return, or on a separate schedule that you attach to the return. The computer will not catch it if you lump the numbers together.
If you are claiming an unusual deduction or there is something confusing on your return, attach a written explanation. Any statements should be as brief and to the point as possible – don't ramble or provide unessential details.
If you are claiming home office expenses or significant travel or entertainment expenses, make sure you have the records. (This is excellent advice for any deduction that you claim. As noted earlier, the IRS scrutinizes these expenses very carefully. The same is true of all business expenses if you haven't yet established a track record, and especially if your business is not profitable.)
Make sure your return is properly completed.
This means that you need to make sure that you:
- Check your arithmetic. The most common errors uncovered by the IRS are caused by poor arithmetic skills. If you are doing your own return with a calculator, after you've done all the computations, we suggest you start at the amount of your refund (or tax you owe) and work backwards to check your work (e.g., add back your payments, subtract your other taxes, and add back your credits to see whether you arrive at the same tax amount; continue in this vein for the rest of the return)
- Make sure that all Social Security numbers for are correct, not only for yourself and your spouse, but your dependents as well. If you are paying or receiving alimony, make sure you supply your ex-spouse's number as well.
- Sign your return.
Not all audits are alike
The IRS has several different levels of audits, ranging from "no big deal" to "uh-oh."
Not every questions from the IRS means you are under audit. If questions arise about your math, items seem to be omitted from your return, or your figures don't match those on your W-2s, 1099s, or 1098s, the IRS may simply request a correction or explanation by mail. Respond to the request as quickly as possible and, if you have doubts about the answer, consult your tax professional if you have one.
Tip
The IRS makes mistakes, too. Don't assume the IRS notice is correct. Check things out. Computer-generated forms, which include the forms most commonly sent out to deal with small errors, are notorious for automatically adding penalties that may not apply in your situation. If you are in doubt, call the IRS and ask them about anything you don't understand.
The first level of inquiry that can truly be considered an audit occurs when you get a letter requesting that you come into the IRS office to review one or more areas on your return. This is a true audit because the IRS is asking for proof of items on your return that go beyond your word.
If you have kept records, including bills, receipts, and canceled checks, you shouldn't worry. The IRS may end up interpreting your situation differently than you, but there is no crime in having differences of opinion. Nevertheless, professional help may be in order with an office audit, particularly if you yourself suspect that there are errors or omissions in your tax return.
Warning
While you always have the option of attending the audit yourself, it might be best not to do so. You can authorize your accountant, lawyer, or other tax professional to handle it without you.
Often this is the best way to prevent the audit from escalating beyond the original areas that attracted the IRS's interest.
Experienced professional advisers are less likely to become emotional or to make statements that lead to more IRS questioning.
If you're in the middle of an audit and find that you are missing some records or need to consult an expert, you can stop the audit midstream and reschedule it for a later date. And, if you run into difficulties with the agent conducting the audit, you can ask to speak to his or her supervisor.
As rare as audits are, the dreaded knock on the door from the IRS agent is even rarer. Individuals are almost never audited in this way. On-site or "field audits" are used mainly for larger businesses, particularly when records are not portable. However, you do get a notice of a field audit, professional help is definitely recommended.
If you disagree with the ultimate results of the audit, there are numerous avenues of appeal that you can pursue. However, at that point, we recommend that you talk to a tax professional to gauge the likelihood of success and the best strategy to use in your particular case. For more information, see the IRS's free Publication 556,Examination of Returns, Appeal Rights and Claims for Refund, available by calling 1-800-TAX-FORM or going to www.irs.gov.