It’s true that the odds of an IRS audit are fairly rare, sitting under 1%. The federal agency has suffered from severe budget cuts over the years, so as a result, the IRS tends to focus their audits on those with large incomes, or where the likelihood of tax issues is high (see: owners of cash businesses).
The IRS uses sophisticated computer systems to come up with targets. For the most part, the actions are automated, too, including a series of letters. And you might be relieved to know that the resolution is usually straightforward — you might have to just provide evidence of a deduction or make an extra payment.
It’s important to be proactive, though. Interest and penalties can add up quickly.
And here and there, the IRS might actually find major problems with your report. If so, the agency will likely want to meet you at a local office or even your own home. At this point, you’ll want the help of a tax professional.
But you don’t have to get to this point. There are a number of steps you can take that will greatly reduce your odds of suffering through an IRS audit.
How to Avoid an IRS Tax Audit: File Your Return
It seems simple, right? You’re supposed to file your tax return every year, so you do.
But not everyone does, and the IRS (surprise, surprise) really doesn’t like it when taxpayers fail to file their returns. That’s because the U.S. system is based on voluntary compliance (which doesn’t mean you don’t have to pay taxes, but instead has to do with individual responsibility to report and pay what you owe).
There’s a myth that the IRS can’t find you if you don’t file a return, but don’t believe that. The agency, while overworked and understaffed, still has tremendous resources and investigative powers.
And the non-filing of a return can result in heavy penalties. The failure-to-file penalty is 5% per month of the unpaid tax bill, for a maximum of 25%. There are even potential criminal actions, including a maximum $25,000 fine and a jail term of up to one year for each year you fail to file.
How to Avoid an IRS Tax Audit: Check for Math Errors
The tax system is complex and requires quite a bit of reporting, so it’s common for taxpayers to innocently make errors.
“But what about tax software?” you ask. It’s true that online tax software does help cut down on mistakes. But you’re forgetting the other aspect of human error — transposing numbers.
When you’re entering data, whether you’re doing it the manual way or going through tax software, double-check your numbers when making entries, then check one last time when you’re all done.
One last thing: Round numbers are a big, red flag, so don’t round up (or down) when you’re inputting information. Rounding will get an auditor’s attention and have them wondering whether you’ve reported a legitimate deduction.
How to Avoid an IRS Tax Audit: Beware of the Sharing Economy
Services like Airbnb, Etsy Inc (NASDAQ:ETSY) and Uber have allowed people to make hefty amounts of side income. However, you might not necessarily get a tax statement from sharing-economy providers, often because the amounts you generate do not meet a certain threshold.
That does not mean you can avoid reporting this income to the IRS.
In fact, the agency knows that a lot of money is being left on the sidelines. According to a 2014 study by researchers at American University, 2.5 million taxpayers earned income that year via sharing economy jobs. The IRS wants its chunk, and it’s going to be more aggressive with auditing these kinds of situations.
If you do make money from a sharing-economy gig, the Sharing Economy Tax Center can explain your obligations.
How to Avoid an IRS Tax Audit: Know the IRS Hot Buttons
Certain types of deductions also raise red flags that lead to audits.
For example, if you cite large amounts of expenses for meals, entertainment and travel (especially to exotic locales), the IRS may want to pursue an audit, believing the deductions are really just personal items.
If you have sizable amounts listed for charities and medical expenses, the IRS also might get involved.
Taking the Earned Income Tax Credit (EITC) — a credit aimed at low- to moderate-income individuals — can also draw scrutiny, just because of the many qualifications involved.
This doesn’t mean you should avoid taking these kinds of tax benefits, but it does mean that if you do, you should be extra certain that your paperwork is pristine, and that you have a solid basis for claiming the deduction or credit.
How to Avoid an IRS Tax Audit: Use a Legitimate Tax Preparer
In most states, a tax preparer does not have to be licensed, so it will come as no surprise to you that fraudulent providers are teeming across the country. They often promise substantial refunds — even if your tax situation hasn’t changed much (a clear red flag).
The IRS has been working to curb this, and unfortunately, that means a lot of innocent people have been dragged into dealing with the agency because their preparers were targeted in an investigation.
The solution? Do your research before hiring a tax preparer. A Google search is a good start, and check to see if the person is a Certified Public Accountant (CPA) or Enrolled Agent (EA).
A helpful resource is the National Association of Enrolled Agents, which will provide listings for nearby EAs.