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Can You Avoid An IRS Audit?
By Don Sadler
Few things are more frightening to micro-business owners than learning that they’ve been selected for an IRS audit.
In reality, the odds of being chosen for an audit are small. Only about 1 percent of all tax returns that were filed in 2009 were selected for audits, reports the IRS. Still, it’s not unusual or even irrational for owners to fear even the slightest chance of being audited.
Keith Hall, a certified public accountant and the NASE’s National Tax Advisor, says that business owners shouldn’t dread an audit if they have nothing to hide from the IRS.
“If you’re honest in completing and filing your tax return and aren’t trying to cut corners, underreport income or claim deductions you’re not entitled to, then an IRS audit is a piece of cake,” says Hall.
The key to making sure the audit process goes smoothly is thorough documentation and recordkeeping, he adds.
Roger W. Lusby, III, a certified public accountant and tax partner in the Alpharetta, Ga., office of Frazier & Deeter LLC, notes that many IRS audits are now simple mail audits, not the more complex face-to-face compliance audits most people envision.
“With these, the IRS simply asks for more details or documentation to support specific items on the tax return,” Lusby says.
Still, most owners would prefer not to find an IRS letter in their mailbox.
So are there actions you can take in preparing your tax return that will help reduce the odds of being audited?
Yes, say the experts. Follow these tips.
Understand How Returns Are Selected for Audits
For starters, it helps to understand how the IRS chooses returns to be audited.
Julian Block is a former IRS special agent who is now a tax attorney in Larchmont, N.Y., and the author of “Julian Block’s Tax Tips for Small-Business Owners” (PassKey Publications, 2010). He explains that the IRS calculates what’s known as a Discriminate Information Function, or DIF score for each filed return.
“The IRS then compares all returns against a national DIF average, selecting those with the highest DIF scores for enhanced scrutiny by experienced IRS examining officers and possible auditing,” Block explains.
The formula used by the IRS to compute a DIF is a closely guarded secret.
“However, the chances of being audited tend to rise depending upon certain types and amounts of income, professions, types of transactions, and types of deductions claimed on returns,” says Block.
The IRS pays especially close attention to returns filed by self-employed individuals, Block notes.
“The IRS believes that most underreporting of taxable income and abuse of deductions occurs among those who are self-employed, so these individuals tend to be audited more frequently than employees collecting a salary.”
File An Accurate Return
Given what we know about how the IRS chooses returns for auditing, here are six actions you can take help keep your return in the clear.
- Double-check your numbers.
“Simple math errors and transposed numbers are the No. 1 reason individuals get letters from the IRS,” says Hall.
This is because the IRS computers may kick out returns with math errors.
“And any time a return lands in someone’s hands, there’s a greater chance that you’ll be hearing from the IRS,” says Hall.
The simple solution is to use a tax filing software program.
“There are plenty of inexpensive options out there, and the IRS even has some free online tax filing programs,” says Hall. “Using software will virtually eliminate math errors and catch other simple mistakes.” - Consider incorporating.
As tax attorney Block notes, the IRS tends to take a closer look at the returns of self-employed individuals, especially those filing a Schedule C.
In 2009, 2.6 percent of taxpayers who filed a Schedule C were audited, compared to just 0.7 percent of incorporated small businesses with less than $250,000 in income, IRS statistics reveal.
“Sole proprietors with large incomes have the highest risk of being audited,” says CPA Lusby. “Once sole proprietors reach a certain level of income and profitability, we usually recommend that they consider converting to a subchapter S corporation or a limited liability company to help decrease their chances of being audited.” - Include documentation and explanations.
If you have unusually large deductions, attach a copy of the checks or receipts to your return to help avoid further scrutiny. And if there are any large inconsistencies in your return from one year to the next, like a business name change or large fluctuation in income, include a brief note of explanation. - Prepare your return early and file on time.
Every year, Hall says he’s surprised at how many taxpayers must rush to complete and file their returns on April 15.
“There’s no reason to wait until the last minute,” Hall says, “So start early. When you’ve finished your return, print it out and put it away for a day, and then look at it again with fresh eyes—paying especially close attention to the numbers.” - Match your stated income to 1099 forms.
If you’re an independent contractor, you should receive an IRS Form 1099-MISC from every client you received more than $600 from the previous year. The 1099-MISC will show how much the client paid you.
The IRS receives the same information, and its computers will compare this to the amount of income you report on your return.
If you report less than what’s stated on the 1099-MISC forms, the IRS may view this as a sign of potential unreported taxable income, a major red flag. In this case, you could receive a letter asking for an explanation of the discrepancy; a bill for additional taxes, penalties and interest; or an audit notice. Therefore, make sure that your reported income is the same as or greater than what’s reported to the IRS on 1099-MISC forms. - Think twice before filing an amended return.
Amended returns tend to attract extra IRS scrutiny—and may even lead to an audit of the original return as well as the amended one.If you catch an error after you’ve filed your return, and that error led to an underpayment of tax, by all means, file an amended return and pay the additional tax (and perhaps penalties and interest) that is due.
If you catch an error that led to an overpayment of tax, weigh the financial benefits of filing an amended return against the potentially higher audit risk.
Take Legitimate Deductions
As a business owner or self-employed individual, you may be entitled to a number of business-related deductions that can help lower your overall tax liability. These include deductions for business miles driven, business equipment, office supplies and maintaining a home office, to name a few.
However, many owners hesitate to take these deductions for fear that they might increase the chance they’ll be audited.
NASE National Tax Advisor Hall refutes this kind of thinking: “If you qualify for a business deduction, you should absolutely take it. Why forgo a deduction you’re entitled to if you’re not trying to hide anything on your return?”
Tax attorney Block concurs: “You should take all valid deductions on your tax return if they are properly backed up with supporting documentation and records.”
These records should be kept for the entire statutory period, Lusby adds, which is generally three years from the filing date.
“However, the statute of limitations for fraud is indefinite, and it’s six years in certain cases of omission of gross income.”
What about the home office deduction? While many people believe that claiming this deduction increases the chance of being audited, Hall isn’t so sure.
“I don’t believe any one particular deduction raises a giant red flag with the IRS more than any other, with the possible exception of the earned income credit.”
Hall notes that the NASE has proposed that the IRS create a standard home office deduction that would greatly simplify the complex process of figuring the write-off amount.
“I believe this would be a tremendous benefit for self-employed individuals and small-business owners.”
Don Sadler is a freelance writer who is busy at work on his tax return and hoping to avoid catching the IRS’s eye. Reach him at don@donsadlerwriter.com.