Keith Mack
Being audited by the Internal Revenue Service (IRS) is something that most individuals and businesses would like to avoid. While there is no guaranteed way to prevent an audit, there are precautions you can take to minimise the chances of being selected. An IRS audit is a review of an individual's or organisation's financial records, accounts and books to ensure that the information reported on their tax return is accurate and compliant with tax laws. The IRS uses several selection methods, including random selection and computer screening, to compare tax returns against norms for similar returns. Therefore, it is essential to understand common audit triggers and red flags to reduce the risk of being audited.
| Characteristics | Values |
|---|---|
| Common mistakes | Careless mistakes, such as math errors, leaving questions blank, or not signing your tax return |
| Reporting a net annual loss, especially a small loss, can be seen as an indicator of underreported income | |
| Filing an amended return, especially if it results in a significant decrease in tax | |
| Failing to include income or inaccurately reporting your income | |
| Large inconsistencies in income from year to year | |
| Excessive charitable contributions for your income level | |
| Business expenses that don't make sense | |
| Unusually low or high business margins | |
| Owning a small business with many cash transactions | |
| Not having supporting documentation for deductions | |
| Undervaluing assets | |
| Not keeping records for at least three years | |
| Not filing on time | |
| Not providing additional context for significant changes in expenses |
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What You'll Learn
Avoid careless mistakes like math errors, blank questions, or unsigned returns
To avoid an audit by the IRS, it is important to be meticulous when filing your tax returns and avoid careless mistakes. Math errors are some of the most common mistakes made on tax returns. These can range from simple addition and subtraction to more complex calculations. To avoid math errors, use tax software that automatically calculates the numbers for you and flags common errors. Review your tax return for accuracy before submitting.
If you are filling out a form and a section does not apply to you, it is generally better to leave it blank than to write "0". However, if you mathematically arrive at zero, you should enter "0" rather than leaving it blank.
Unsigned tax returns are not valid. To avoid this, file your return electronically and digitally sign it before sending it to the IRS. If you are filing jointly with a spouse, both of you will need to sign the return, unless an exception applies.
Filing your taxes too early can also lead to mistakes and potential delays in processing. Make sure to wait until you have received all the proper tax reporting documents before filing.
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File on time and do it right the first time
Filing your tax return on time and doing it right the first time can help you avoid an audit. While there is no guaranteed way to avoid an audit, you can take precautions to keep your business from raising red flags.
An IRS audit is a review or examination of an individual's or organisation's books, accounts, and financial records. The purpose is to ensure that the information reported on their tax return is correct and complies with tax laws, and to verify the reported amount of tax.
Filing on time creates a history of compliance and can help you avoid penalties and interest charges. It also shows that you are taking your tax obligations seriously. If you file late, you may be charged penalties and interest on any unpaid taxes. In addition, filing on time gives you the opportunity to correct any mistakes or omissions in your tax return. If you file an amended return after the deadline, it could be flagged for manual processing and closely examined by the IRS, increasing the chances of an audit.
Doing it right the first time means providing complete and accurate information, including all required documentation and supporting evidence for any claims or deductions. Avoid careless mistakes such as math errors, leaving questions blank, or not signing your tax return. These types of errors can trigger an audit. Make sure to report all income and only claim deductions that you are entitled to. If you have any sudden changes in your expenses, provide detailed explanations and attach additional paperwork to your return. This can help address potential questions and reduce the likelihood of your return being flagged for further review.
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Provide supporting documentation for any deductions
While there is no guaranteed way to avoid an audit, providing supporting documentation for any deductions is a good precaution to take. The IRS will be looking at returns where the numbers are higher than normal, so be prepared to provide receipts and documentation of where and when meals or other expenses took place, who was present, and how it related to your business.
If you claim a deduction for a medical expense, make sure it is a “qualifying" medical expense. If you were reimbursed for the expense by your insurance company, you cannot claim it. Similarly, if your employer provides health insurance and pays part of your premium, you cannot deduct that amount. If you are self-employed, you can deduct health insurance premiums and premiums for qualifying long-term care policies for yourself, your spouse, and dependents.
If you own a business, be aware that the IRS will take notice if you claim losses year after year or if a loss is substantial. Keep careful records for at least seven years that detail every dollar coming into and going out of your business. If your business is a sole proprietorship, the IRS may question whether it is more of a hobby, in which case the loss may not be deductible. If you are claiming a home office deduction, keep good records, including photos of the office environment.
If you are claiming deductions for charitable contributions, be honest and report the actual amount you donated. Avoid suddenly including a large number of deductions you've never taken before, as this may increase your chances of an audit.
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Avoid excessive charitable contributions
While there is no guaranteed way to avoid an audit, there are some precautions you can take to avoid raising red flags. The IRS audits tax returns to ensure that the information reported is correct and that the reported amount of tax is accurate. One of the most common red flags is underreported income, which can be due to a missing or out-of-date 1099 form, inaccurate accounting practices, or both.
When it comes to charitable contributions, if you donate an excessive amount, it can trigger an audit. For example, if you earn $45,000 per year and donate $15,000 as charitable contributions, the IRS is likely to scrutinize your return. However, this doesn't mean you should defer your donations to avoid the hassle of an audit. If you have nothing to hide, you have nothing to fear. If your contributions are legitimate, the IRS will likely thank you for your generosity and move on.
To avoid raising red flags, keep the following in mind:
- Keep records and receipts of your donations. If you can prove that your contributions are legitimate, the IRS will have no reason to continue their investigation.
- Attach a copy of your receipt to your tax return. While it's unclear whether off-the-shelf tax software allows this, professional tax software used by CPAs does.
- Be prepared to show not only your receipt but also proof that the payment came from you, such as a cancelled check or a copy of a paid cashier's check.
- If you receive a letter from the IRS regarding your charitable contributions, respond promptly with the necessary documentation. This letter is technically an audit, but it's the weakest form of investigation, simply checking for potential typos or errors.
- If you donate to a legitimate charity and have an acknowledgment letter, there's no need to worry. The IRS has more important issues to address than questioning your generosity.
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Avoid large inconsistencies in income
While there is no guaranteed way to avoid an IRS audit, there are several measures you can take to reduce the risk of inconsistencies in your income being flagged. Firstly, ensure that all your income is accounted for and correctly reported. The IRS receives copies of your W-2 forms from employers and 1099 forms from other sources of income, and they use data-matching technology to compare this with the income reported by employers, financial institutions, and other third parties. Discrepancies can trigger an audit.
If you have multiple sources of income, including business income, capital gains, dividends, interest, rental income, or royalties, be especially diligent in reporting these. Taxes are not usually withheld from this type of income, so it is more prone to discrepancies. For example, if you work a side job for a company that reports your wages as a business expense, ensure that you also report this income.
If you own a small business, always report your earnings or losses using Schedule C, which is the IRS tax form for reporting profits or losses for your business. This will give you the best chance of avoiding an audit.
If you are self-employed and work from home, you can deduct home office expenses. However, regular employees do not qualify for this, even if they pay out of pocket for their home office setup.
Finally, be aware that the IRS continually adapts its approach to performing audits based on taxpayer filing behaviour. They issue notices on their website about what they look for when performing audits, so it is worth checking this when preparing your tax return.
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Frequently asked questions
Although there is no guaranteed way to avoid an audit, there are precautions you can take to keep your business from raising red flags. Avoid careless mistakes such as math errors, leaving questions blank, or not signing your tax return. File on time and do it right the first time.
Some common red flags that trigger an audit include underreported income, large inconsistencies in income from year to year, and excessive deductions.
To reduce your chances of being audited, you should understand how the IRS performs audits and what they look for. You should also keep thorough records and ensure that your tax returns are accurate.
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