How to avoid a tax audit, and how to prepare for one

Posted on June 18, 2009 by Teanna Hart

As you fIle your tax return, do you wonder whether you’re likely to get audited?

You can take some comfort in the fact that audits are remarkably rare, hitting about 1% of taxpayers each year. However, the rate is rising, and if you happen to pull a few audit triggers, your chance of getting that ominous letter or phone call from the Internal Revenue Service can soar tenfold or more, experts say.

"I am hearing about more audits than I ever have," said Roni Deutch, a tax attorney in Northern California who has been practicing for 17 years. "People will try to alleviate your fears and tell you that an audit is not a big deal. It is a big deal. It’s like having a root canal without Novocain."

The number of returns audited by the IRS jumped 7% last year to 1.38 million, up from 1.29 million in 2006.

If you’re an honest taxpayer, you should never avoid taking a legitimate deduction just because it Inight trigger an audit, said Jeff Schnepper, author of "How to Pay Zero Taxes."

But you do need to be aware of the things that Inight get you audited, the different kinds of audits, and how you ought to deal with them.

The triggers

Your odds of an audit hinge partly on something called a DIF score. The formula is closely guarded by the IRS, but tax experts have identified some factors that are likely to boost your score and thus your chance of an audit:

• Unusually high deductions. Deductions that stray from a normal range will cause your return to get further scrutiny. But what’s normal? Each year, the IRS publishes a "Statistics of Income" book that shows the averages.

The one caveat: The average in each category takes into account only those people who claimed deductions in that category. As a result, the averages overstate how much a typical taxpayer deducts.

For example, for people earning between $15,000 and $30,000, the average deductions are $6,229 for medical expenses, $2,761 for taxes, $6,664 for interest and $1,969 for charitable contributions. But if you earned $15,000 and claimed all those deductions, you’d be writing off $17,623 - more than you earned. Even though each deduction was "average," would you be audited? Without a doubt.

• High income. Your neighbors may envy you if you make $1 million or more, but they won’t be so envious of your status as an IRS target. In its latest fiscal year, the agency audited 31,382 million-dollar earners, up 84% from the year before.

That meant your chance of getting audited was 9.3% if your income topped $1 million, compared with only 1% for taxpayers overall.

You don’t have to be a millionaire to deserve more than your share of IRS scrutiny, either.

The agency targets anyone with more than $100,000 in income. It’s just that your chance of getting audited jumps with every big step up. If you earn less than $100,000, you have a 0.93% chance of being audited, for example. Earn more than $100,000, you have a 1.77% chance. Earn more than $200,000 and your audit odds jump to 2.87%.

• Cash businesses. If you have a job in which you Inight be paid in cash - say you’re a bartender or a hairdresser - the IRS is likely to look closely at your gross income to deterInine whether you failed to report everything you earned. A telltale sign: You deposit more in your bank or brokerage accounts each year than you report as earnings on your tax return.
• Self-employment. Tax authorities target self-employed people because they’re often aggressive - sometimes abusive - in writing off day-to-day expenses.

As long as your deductions are legitimate, Schnepper said, you should take them. And many can be legitimate.

"There’s very little that you can spend money on that I cannot make deductible for someone who runs their own business," he said.

But if you do write off aggressively, know that your deductions are likely to be scrutinized.

• Errors. You gave $1,100 to charity, but your finger stuck on the "zero" key when doing your taxes and you reported $11,000 instead. Or you transposed two digits in your child’s Social Security number - or failed to report $57 in income from your bank checking account. All these errors are understandable, but they’re going to cause the IRS computer system to toss your return out to a human to ask you for more information.

Types of audits

There are two types of IRS audits: correspondence audits and field audits. The good news is the vast majority of audits are correspondence audits, which can be as simple as the IRS asking you a question by mail and having you respond by mail. The simple errors described above, for instance, are likely to generate a letter asking you to explain the discrepancy.

If you goofed, admit it and pay whatever additional tax you might owe. If you didn’t, provide the requested information and explanation. There’s usually no reason that you can’t handle a correspondence audit by yourself, but pay attention to the deadlines. If you need more time, ask for an extension. If you ignore a correspondence audit, it can turn into a much more onerous field audit.

"As long as you remain engaged in the process and provide them with an adequate response, the audit is done," Deutch said.

"If you don’t respond," she added, "you have screwed yourself right out of the gate."

If you are called into the IRS offices, or an agent wants to visit you to see your records, the review is likely to be broader and more serious than a correspondence audit. If you don’t already have one, it may be time to consider hiring a professional to represent you. Even if you’re damant that you’ve done nothing wrong, you might need help knowing what the auditor is looking at and what information you need to provide.

Defense strategies

Some other ways to deal with an audit - or the prospect of being a high audit risk:

• Head ‘em off. When you claim an unusually large deduction, Schnepper said, consider adding a note to your return explaining the write-off. For instance, if you earn $50,000, a $10,000 deduction for donating used clothing to charity is likely to stand out. But you might have this rare situation if you inherited the contents of your late grandfather’s home and opted to donate them. In such a case, it might help to give the IRS a heads-up.

"Take exactly what you are entitled to," Schnepper said. "But if you have an out-of-proportion deduction, I would just get the documentation and attach it to the return."

That way, when the computer spits the return out for greater scrutiny, an IRS employee will see that you’ve already explained the red-flagged item. That might tum off the alarm and head ofl"the audit.

• Prepare. Always keep good records and keep particularly meticulous records of anything that you know is likely to be an audit trigger.

"Picture dead presidents on every one of your receipts," Schnepper said. "If you are audited and you don’t have a receipt, you don’t have a deduction."

Being prepared also allows you to respond to IRS requests promptly. The more quickly and thoroughly you respond, the less the IRS worries that you’re a scofflaw, Deutch said. Moreover, if it turns out that you owe money, interest accrues on it every day. It’s in your best interest to be quick.

• Focus. The IRS will always tell you what information it is looking for when you’re being audited. Provide that information and no more, Schnepper said. The biggest mistake people make in an in-person audit is engaging in idle chatter, he said.

If the agent is looking for one thing, but you nervously babble about everything else, the agent may get interested in a part of your tax return that otherwise wouldn’t be scrutinized, he said. And every new area creates risk - risk that your records aren’t adequate or that the IRS won’t see the deductions your way.

• Be polite and professional. If you’re angry about the audit, keep it to yourself or seek therapy. Don’t take it out on the auditor.

"When people are combative, they just make things worse for themselves," Deutch said. "The auditors have husbands, wives, families. Treat them like you would want to be treated and I promise you, your audit is going to go so much better."