Without even the IRS knocking at your door, or sending a stern letter saying you cannot “pull a fast one this time,” tax time is already irritating enough. Nevertheless, IRS audits are to make sure everyone pays their fair share. The IRS has several measures that automatically trigger an audit and process millions of tax returns in a short time. It may not necessarily mean that you have done anything unlawful; maybe the return you filed failed to show convincingly that you are not out to defraud the IRS. If you file your return correctly, you should be able to prove that you are paying all your taxes. The IRS will have to agree with you and leave your return as such, leaving your audit without any fine, or worse, jail time.
An audit is conducted either by mail or in person with three possible outcomes:
- The IRS finds out the return is correct and hence it stays unchanged.
- The IRS finds irregularities and you agree to the changes hence pay more taxes, interest, or a penalty (maybe forfeiture of property and jail time in rare extreme cases)
- The IRS makes changes to the return and though you understand it, you do not agree to it. You can then appeal or enter into mediation with the IRS.
The following are some top reasons for the IRS to audit your return, how to identify if you are wrong, and what proof you will require to deter a total audit, fines, and often, humiliation:
1. Reporting Incorrect Taxable Income
Your W-2 and 1099 forms are available to both you and the IRS for both full-time and freelancer employees, so you cannot cheat about your taxable income. It is perfectly okay to cite a small math error since the IRS will correct it. It is however not okay to estimate how much you make even if you are a freelancer. To avoid this compare the 1099 you receive with your records. If it is wrong, inform your company and ask they file the correct 1099 with the IRS.
2. The Home Buyer Credit
The first-time homebuyer credit was made available to those who bought a home for the first time after April 8 2008 and before January 1 2010. This is like an interest-free loan of up to $8,000 from the government. If you claimed the credit in 2008, you pay back the loan over a period of 15years by paying an additional tax. If you took the credit in 2009 and 2010 (and 2011 for service members), you do not have to pay it back.
Some people trying to defraud the IRS have misused this credit. So the IRS will scrutinize anyone claiming this credit to exclude people who are flipping homes or speculating in real estate. They check to see if you have lived in the home for more than 36 months as per the requirements. It is okay if you bought your first home and will be living in it for a while. It is not ok if you bought your first home and sold it within three years for a profit, or made another home your primary residence. You need to pay back the credit in full when you pay your taxes that year. Always keep all records about the purchase of your home as proof of legitimacy.
3. Huge Donation on a Small Budget
The IRS will be suspicious if you make large charitable donations when you do not have much income. It is ok if you gave a generous donation to your alma mater but lost your job suddenly, thus making your income lower. It is not ok if you trying to give made up charitable deductions. Make sure you keep all charity receipts and follow IRS’s tips for charitable donations. Appraise your donations.
4. A Steak Dinner with the Clients
It is ok to deduct 50% of the cost of a reasonably priced meal where you entertained potential clients for your business. It is not ok to deduct that cost by citing travel expense. Keep all receipts and record the dates and times, descriptions of the expense, the business purpose, and business relationship.
5. Using Your Car for Business
It is ok to use the car to make minor deliveries to clients using your car, but it is not ok to drop off deposits at the bank on your way to personal errands. Keep a record of mileage and calendar entries for every time you use the car for business.
6. Your Home office
It is ok to have a study where you keep your work accessories and do majority of your work, but it is not ok to have a desk at one corner of a room where you work a few hours a week.
This is one of the top reasons for audits. The IRS fixes small math errors. However, claiming wrong deductions and credits, stating the wrong income and filing wrong statuses are not ok. You need to double and triple check all your returns before filing them Keep copies of your returns and records.
8. Round Numbers
Avoid having little tidy numbers since the IRS may assume you are making things up. Round of to the nearest dollar. Do not do things from memory and rounding off to the nearest $25. Have documentations for your deductions and credits, and use actual numbers on your forms.
9. A Business That Loses Money
If someone with a business reports losses for two consecutive years, the IRS have reason to look closer. It will be ok if the business did not do well for some time but you have something else generating income for you. It is not ok to show losses in a business yet you have no other source of income. You should have proper documentation for the business to prove it made a profit or loss at least three of five years.