For most people, getting a letter from the IRS creates instant anxiety. The IRS has tremendous powers; it can garnish your wages, put liens on your property and even put you in jail! So how do you avoid a tax audit?
The department has an intimidating reputation for sure. But for the most part, IRS audits are fairly rare. Based on historical trends, it’s likely to be under 1% for the current tax season.
What’s more, most audits are done through the mail. Only a small number even involve visiting a local IRS office.
However, an audit can still be expensive, time consuming and stressful. But the good news is that there are strategies you can take to help minimize the risks.
So here’s a look:
Tips for Avoiding a Tax Audit #1: Report All Your Income
The main trigger for a tax audit is the non-reporting of income. Note that the IRS uses sophisticated computers to match tax returns with filings from payers. For example, when a company pays a contractor, there will be a 1099-MISC filing — that discloses the compensation — that will go to you and the IRS. In other words, if the amount does not show up on your tax return, then expect a notice.
But what if you got a check or cash and the payer did not file the 1099-MISC? Well, you still need to report the income.
True, the IRS may miss this. But if you get targeted for a full audit, there will be a review of your bank accounts. If you cannot explain why an amount was deposited, you will likely be subject to penalties, interest and payment of the tax owed.
Tips for Avoiding a Tax Audit #2: Take the Time to Avoid Innocent Mistakes
Even if you use a service like Intuit’s (NASDAQ:INTU) TurboTax, it can still be easy to make mistakes. A common example is to transpose numbers. But another problem is that some deductions and credits involve multiple steps and can get complicated.
In light of this, you should not rush when doing your return. Make sure you double check your work.
Something else to consider is that you may forget a tax document, say a 1099 or even a W-2 form. As more of these documents are sent via email, there’s a chance that one of them could get lost in the noise or even get stuck in your spam filter.
To help avoid these problems, a good approach is to put all your tax documents in one place. This will go a long way in reducing the number of mistakes.
Finally, a red flag for an audit is the high frequency of round numbers, which may indicate that you are making things up! This is why you should input the numbers as is.
Tips for Avoiding a Tax Audit #3: Back Up Your Deductions and Credits
There are certain deductions and credits that are red-hot targets for audits. For instance, some may have high rates of fraudulent abuse, such as the Earned Income Tax Credit (EITC). But in other cases, there are deductions that have higher likelihood of being exaggerated — say with the valuation of donated property.
Now this does not mean you should avoid these tax advantages. But it is important to know the rules and follow them. You also need to make sure you have the documentation to back things ups.
Tips for Avoiding a Tax Audit #4: Take Extra Care If You Run a Small Business
If you have a small business, there are many deductions you can take. But small business owners can often take tax breaks for what the IRS considers personal expenditures (such as travel and meals). So it should be no surprise that small businesses are a common target for audits.
In fact, if a small business operation loses money for three straight years, the IRS may consider the business to be a hobby, which can cause major tax problems.
Because of this, it’s probably a good idea to get the assistance of a tax professional. After all, some businesses legitimately may lose money for a prolonged period but there will need to be well-grounded arguments for the IRS.
Tom Taulli is an Enrolled Agent and also operates PathwayTax.com, which is a tax advisory and preparation firm. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.