Audit Triggers - Part 2

Yesterday I published a couple of likely triggers for an audit. As promised, here are a couple more:

High Income – Although a higher income should be considered an advantage under any other circumstance, considered from the perspective of prospective audits it is most certainly a disadvantage. And the chances of an audit jump up significantly with each income level. Past audits tell us that the chances of an audit for taxpayers making less than $100,000 is 0.93%. For incomes over $100,000 the chances jump to 1.77%, over $200,000 brings the odds up to 2.87% and over $1 million in income brings the chances of an audit to a whopping 9.37%!

Self-Employment – Because self employed taxpayers are constantly keeping an eye on their bottom line they tend to be aggressive at writing off expenses. While there are many legitimate reasons for doing so the IRS likes to verify these deductions.

While these are some of circumstances that may trigger an audit they do not necessarily guarantee one nor will avoiding them remove all possibility of one. The best defense against an audit is to always expect one. Taxpayers should make sure that their deductions are legitimate and reasonable. They should also keep well ordered records and receipts.

However never having to face an audit is certainly the best circumstance. Keeping these triggers in mind can help taxpayers reduce the risks of that happening.

Audit Triggers - Know what the IRS is looking for...

With the tax clock ticking down lots of people are finishing up their tax returns. A common question that comes up during this joyous time of year is, “How can I avoid an audit?” Fortunately for most taxpayers the question is far more common than an actual audit. Only around 1% of all taxpayers actually end up facing an audit.

Comforting as that fact is, it is in no way instructive. Knowing what is more likely to trigger an audit can go a long way to avoiding one. Avoiding these triggers will not guarantee that an audit will not occur but it will reduce the chances of one. While all of the reasons that the IRS launches an audit aren’t known, crunching the statistics of past audits does demonstrate some clear triggers.

High deductions – Any deduction that is proportionally high to the taxpayer’s income usually constitutes a red flag. Determining what’s high is the trick here. The IRS publishes an annual book, “Statistics of Income.” Although the book gives ranges for typical incomes some logic needs to be applied. If a taxpayer is at the lower end of a particular income range but claims the upper limits of deductions associated with that range then that deduction may still trigger an audit review even though the deduction is technically within the accepted limit.

Cash Income – Any profession that deals with a lot of cash, such as waiting tables, tends to spark the curiosity of IRS audit agents. One of the first things they compare in cases such as this is bank deposits vs. claimed income.

These are a couple of common triggers that can set off an audit. Tomorrow I'll share another couple of potential red flags. Remember, avoiding these doesn't necessarily guarantee avoidance of an audit but it can certainly reduce the possibility of one.

What’s Keeping You Honest?

Most people are honest and most honest people are that way for two reasons. First because they feel that being honest is the right thing to do. Second they are honest because they fear the consequences of getting caught being dishonest.

I suppose that that’s common sense but IRS decided to take a poll to make sure. They found that 84% of people believe that cheating on one’s taxes is unacceptable. But 54% said that they don’t cheat because of fear of an audit. Further 61% admitted that they accurately report their income because they knew that a third party like their employer or clients had already reported their income. But 87% said that personal integrity also played a role.

So, basically, we’ll cheat as long as we think we can get away with it and as long as we can feel good about ourselves while we do it. Sounds about right to me!

Audits - Be Prepared

In a previous post we looked at the likely-hood of any one taxpayer facing an audit. While the odds are low, every US taxpayer should be prepared for the possibility of an IRS audit.

Anyone that claims deductions beyond the standard deductions should be prepared to defend their tax return. Self-employed worker, small business owners, anyone claiming investment losses or virtually any other financial circumstance beyond the usual salary minus standard deduction scenario should be prepared.

Taking deductions or claiming that certain expenditures are business expenses reduce the total taxes owed. The IRS expects make taxpayers to make such claims. Deciding what is a legitimate deduction or business expense is left largely up to the taxpayer and her advisors. Deciding whether to accept them is up to the IRS and, in the case of an audit, the auditing agent. Therefore surviving an audit depends on being prepared to defend the deductions taken.

Good record keeping is the key to being prepared. Save all receipts and keep them in an orderly way so that if an audit ever happens locating them will be easy. Keep records of all transactions that affect each year’s taxes – both income and deductions. Make sure that all transactions are clear, traceable and can be explained. Maintaining honest and straightforward financial records will offer most taxpayers the ability to survive an audit.

Will You Face an Audit?

Probably not.

It’s the dread of every US taxpayer – the IRS audit. Most citizens only have a vague idea of what an audit is and how to prepare for it. Everyone has heard nightmarish stories of audits – lost receipts, probing questions about deductions taken years ago, and, the worst, owing huge sums of back taxes. The audit has been called the financial equivalent of a rectal examine.

The odds of being audited by the Internal Revenue Service are really quite slim. Of 131 million returns received by the IRS for the 12 month period ending October 2005, only 1,216 were audited. But it’s a perpetual possibility for which everyone must be prepared.

Many taxpayers take the standard deductions and will never have to worry with the years of old receipts and financial records from the past. In fact if the IRS decides to take a look at the tax history of a citizen who has only taken standard deductions, chances are she will never know that she was investigated. The IRS agents will simply look at her past returns, see that she took the standard deductions, and move on to the next taxpayer.

IRS Plans Random Audits

So, you’ve done everything right and completely above board on your taxes. You even rejected some of your accountant’s suggested deductions because they seemed a little close to the edge. Nothing, you told yourself, to raise any flags with the IRS. The money lost over a deduction or two was worth knowing that you wouldn’t face an audit.

Well, things have changed and even the most studiously honest tax returns may face review. The IRS is bringing back a controversial audit lottery that will randomly target taxpayers. Apparently no groups will be given special attention and no one is exempt from being possibly selected.

The first bunch of 13,000 tax payers will be selected from various income categories this autumn and reviews will commence in October.

Is there anything that you can do to prepare? Not really. Some audits will be carried out without the taxpayer even being aware that it is happening. If the IRS is able to confirm the return with their records then the investigation will stop. But most cases are expected to result in some face to face time with the taxpayer.