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The Dread Tax Audit: Triggers and Tips

The horror, the horror: I’m being audited!

Summertime… and the living sure seems easy. You’ve fired up the grill. The dog has just relieved himself on your mother-in-law’s prized azaleas leaving you with feelings that strangely mingle distress and satisfaction. March and its bitter winds seem far away; tax season is long gone. And yet, here comes your spouse with the remains of yesterday’s mail, brandishing a shredded envelope high: something’s not right. Your hands, already damp from the heat of the coals, grow sweatier still as you take in the contents of the letter; the flies circle above your head like vultures. You’re being audited! The IRS has you in its sights!

Don’t panic!

First, don’t panic. And don’t toss the notice on the grill in a fit of pique; it’s hardly a suitable condiment for your burger in any case. Above all, don’t ignore it! The IRS audits just above one in every hundred individual returns every year: that’s a solid number, one that furthermore is going up as technological advances make the agency’s snoop and sort job easier, and as it hires more auditors to crawl over suspicious returns. Most audits address sins committed in the previous year, but some arc back to previous years. How many years back can the IRS audit your business? The correct answer is three. So it’s wise to keep your records in order for at least that long on the off-chance you get the dread call.

Not all audits are created equal.

Second, remember that not all audits are created equal. There are three types of audits. In the simplest instance of a correspondence audit, which applies to the majority, the filer receives a letter requesting additional information, often on a specific section of the return, which he can then forward to the IRS via mail by the requested date. Next in line, cranking up the level of complexity somewhat – and apprehension surely, is an office audit which surveys a wider swath of the return. In such a case, you would be required to visit an IRS office, paperwork in hand, and invited to go over the return to address its discrepancies. Last, but very far from least, roughly two percent of all audits undergo an actual field audit. This is a “Matrix” moment of sorts, when an audit officer, presumably suited if not dark spectacled, pays you a visit in your home or place of work and begins with something like… “Mr. Anderson” before proceeding to have the contents of your financial suitcase sniffed at like so much dirty laundry. Welcome to the desert of the real indeed.

How the IRS moves your return to the audit pile

Obviously, you want to do all you can to avoid getting to that sorry spot. But before we run through some of the triggers that alert the IRS to the potential need for an audit, and furnish you with some necessary tips to dodge an appointment with the man in the suit, it helps to have a cursory understanding of how the IRS evaluates a return for its, ahem, auditable content. The IRS computer geeks have come up with program that scans your return and assigns a score to it. This discrimination Information function (DIF) score is based on an algorithm that is as closely guarded as the secret recipe of your favorite cola. But if we have no way of knowing exactly how the numbers are crunched it stands to reason which are. The IRS surveys your income, the deductions you’re taking, what credits you’re claiming, and relates them both to each other and to outside factors such as your place of residence, the size of your family, and your profession. Your deductions, for instance, are compared to those of others in your income bracket and, bluntly put, if they appear excessive relative to your income, your return is issued a high DIF score and gets slotted for potential review by an actual humanoid trained to smell a rat.

What did I get wrong?

If you used the service of a qualified tax preparer, you’re probably juggling some choice insult as you watch the embers glow and the meat char on that otherwise fine summer day. Eventually, you’ll coax your memory into remembering their number and call them to sort out the mess. But if you did your own taxes you’re surely wondering, well, where did I go wrong. Recall the three main prongs that underpin the DIF formula: income, credits, and deductions. It’s likely you got one or more of these wrong: you may have under-reported your income, perhaps omitting to include the amount from that 1099 you accidentally misplaced; you took deductions that were not allowed, thinking they were legit when they in fact qualified as bogus; you claimed a credit which you had no right to. Any, or all of these, popped up red flags, discrepancies that were picked up by the IRS sensors. We’ll address each category separately.

Income related triggers

It is not impossible for the straight as an arrow nine-to-fiver who has his taxes deducted from his salary by the company he works for, and customarily opts for the standard deduction, to get roped into an audit, but in all probability he won’t. He might though if he filed his own return and got tangled in his math. Which allows us to introduce our first tip; it’s usually dropped in somewhere at the end but we believe in pushing it up front. You don’t want a simple mistake of arithmetic to get your return moved to the front of the audit line. So,

Tip 1: Get your numbers right when doing your return!

And while we’re at it, remember that 1099 that went AWOL? So, here’s

Tip 2: Gather up all your records!

But if anyone, at least potentially, can get audited, some professions or ways of earning an income are much likelier to be targeted for an audit. This is because the IRS assumes, based on past instances, a measure of unreported income in such cases. Examples of professions that activate IRS suspicion are, foremost, those that primarily involve cash transactions. These would include bartender, taxi driver, hair dresser, barber, party stripper – What was that, you ask? Worry not, we’ll meet her again: she’s has a surprising part to play at the end of our story – etc. Tip #2 is meant for them. So, if you get paid in cash,

Tip 3: Make sure to have proof of payment for cash earned!

Proof of payment must include the amount paid, the name of the payee (that’s you), and the date on which the payment was made. Professionals who manage their own books, doctors, lawyers, accountants, and so on, also fall under the same rubric. And, remember that in our days of blissful interconnectedness the IRS will look at your bank account deposits; you want to make sure your calculated income comes close to the total of your deposits.

Staying with deposits in relation to audit triggers, please note that large cash transactions, of amounts close or in excess of $10,000, involving banks, currency exchange, or casinos, and flagged as suspicious by the institution get pointed attention from the IRS. If you walk in a casino looking to exchange a large sum of cash for chips, be prepared to substantiate the legality of your transaction.

Finally, be sure to report any offshore accounts you may have opened. And if this is the first instance of such reporting to the IRS, make sure to keep detailed reports of the date at which the account was opened.

If you choose to file sweeping losses on your Schedule C for an activity which, however dear to your heart, could be construed as a hobby, such as sailing, horse-breeding, or winemaking, you render your return substantially more attractive to the potential auditor. That’s because a hobby is a hobby is a hobby until it can be demonstrated to be profit generating at which point it can legitimately be called a business. The number of years during which the activity must be shown to have garnered a profit is at least three out of five, but be aware that the exact number varies depending on the hobby. So, get that filly racing, sell some of those bottles of precious elixir, or use that boat to teach fledging mariners. And, it goes without saying, keep thorough documentation of all expenses incurred tending to that hobbyhorse of yours.

Credit related triggers

You should always remember the following about government issued credits: they have a shelf life. In other words, they are set to expire at some point, either because on your side, for instance, children who could once be declared dependents no longer are, having moved out of the ancestral home to their own pads, or because the powers that be choose to rescind the credit. Credits taken on a return are scanned for applicability by the IRS and can potentially raise all of kinds of audit inviting red flags. Therefore, another noteworthy tip goes:

Tip 4: Make sure you understand clearly what a credit is about before you opt to claim it!

Let’s run through a pertinent example. You should watch out if you take the homebuyer credit as a homeowner or first-time homebuyer. You need to know that as a first-time homebuyer you must attach a copy of the settlement to your return – that would be Form HUD1, which must be complete and conforms at a minimum with the local laws of your state. If you have been a homeowner of long standing and are taking the credit, you should attach proof of prior ownership. It must show that you have lived in your previous home for a period of five consecutive years during an eight year stretch ending on the date of purchase of your new home. Documentation of this five year span can be any of the following: a copy of Form 1098 documenting mortgage interest paid on your prior home; your property tax records; your homeowner’s insurance records. Note that a certificate of occupancy is not by itself admissible. If you think about it, there are good reasons why this particular credit gets the IRS buzzing. People often get the dates and time specifications wrong. For 2010, for instance, many may miss the fact that while the homebuyer credit was extended to September 30th this also meant that their contract had to be finalized by the 20th of September for them to be entitled to the credit. Or, in a flagrant misunderstanding of its purpose, some may believe their vacation homes or rentals are eligible for the credit. They are not, period. Only if the home qualifies as your principal residence does it qualify for the homebuyer’s credit.

Deduction related triggers

Deductions are closely related to credits, if anything because filers tend to approach them with an even greater degree of assumption and misapprehension, and they’re as potent a source of audit triggers. Certainly, you should claim any deduction you believe in earnest you have the right to and, as we will see below, you should be prepared to take the matter of a disallowed deduction to the courts if you think you have a convincing enough case. But you must always remember the following which we’ll wrap into

Tip 5: If your deductions seem disproportionate to your income you will set IRS alarms going!

To reiterate in simpler terms, if you’re not making the income to justify the large number of deductions you’re taking you may cause your return to be moved to the front row of those potentially selected for closer examination by an auditor. If that is the case, make sure to have detailed documentation to justify the deductions.

Speaking of documentation, typically in the form of receipts, cancelled checks, and the like, it might be useful to drop another tip before we move deeper in the thicket of deductions. Here goes,

Tip 6: There are ways to prove deductions even if you don’t have a receipt!

These could include: oral testimony that is believable and factual, which is to say, no dog ate my homework excuses; an affidavit, meaning a sworn written statement made before an officer from X that you paid him to do Y; a receipt of thanks in the case of a charitable deduction for the amount of the donation you made; a reconstructed record of the transaction. Note also that bank statements are adequate as proof of payment made via electronic fund transfer (EFT). Finally, always remember that if you’ve forgotten the details of a deducted transaction mentioning it to the IRS can earn you some beneficial and deserved good will.

Deductions are a minefield of audit triggers for three historical reasons: many of those claimed are misunderstood; quite a few are out-and-out bogus, not to say hilarious; a select few are painstaking to document and validate. Indeed, the IRS pays special attention to those items where filers have historically failed to retain adequate substantiation, so we’ll start with those, in particular everyone’s favorite: meals, travel, and entertainment.

Meals, travel, and entertainment: you’ve met those before, especially but by no means if you’re self-employed or in sales. That’s the one where you choose to serenade the attractive representative of the account you’re pitching with a night out at a reputed eating establishment, perhaps followed by front court seats at the game, etc. As you can imagine, there’s lots of room for fudging here: personal meals get filed as business; tickets for the family’s night out on Broadway get deducted; the business contact becomes a “friend” and business becomes “risky”. Well, the IRS agents are no chumps. To defuse a potentially embarrassing enquiry into your affairs, let’s first recall tip #5: if your earnings are outmatched by your deductions, if you’ve been dining at four star restaurants on a small k salary, be prepared to furnish the IRS with detailed documentation of your business related entertainments. These must take the form of receipts – any expense above $75 currently required a receipt – and information regarding the places visited or lodged at while traveling, the persons involved, the nature and purpose of meetings. Make sure then to record the amount paid, the name and location of the eatery, the cost of the cab to get there, the name of your business contact. And don’t omit the topic of discussion. To obtain the deduction you must talk business before, during, or after the meal. No reason not to enjoy yourself, clearly. But please resist the temptation to deduct an expense that your company is compensating you for. That would be a fine example of a bogus deduction, not to mention an illegal one.

Vehicle usage is another area littered with booby traps. First, be very wary if you intend to claim the full business use of your car. Most people own a vehicle for mixed usage, which makes exclusive business use both unusual and remarkably difficult to convincingly substantiate. Needless to say, it attracts and warrants all manners of unwanted attention. In such a case, pay acute attention to your records. Mileage logs must be detailed and thorough; calendar entries must be precise. Both are good advice to follow even if only an established percentage of the use of your vehicle is for business as is proper. Again, going back to a prior tip, there are ways to demonstrate usage that you may not have thought of. A written diary of miles used for business is generally acceptable. A spoken recording would also be sufficient. One final note: if your car is used as an advertising platform for your business, you can only deduct the cost of material and of the labor incurred in creating the ad, not the full cost of the vehicle.

As with your car so with your house: home office deductions are looked at carefully by the IRS. That’s foremost because, irrespective of the actual amount claimed, people often overstate their claim as they do not fully grasp the requirements to establish the proper deduction. The notion of exclusivity again comes into play: any space claimed must be used solely and regularly as your main place of business. Sole use implies that no other activities are conducted there. Thus a writer’s den would in principle be used only to produce work for publication not as a local for drunken revelry; a jeweler’s studio only to make ornaments to sell, and so on. If you’re not sure, it might be wise not to take the deduction. And, in another glaring instance of bogus deducting, do not attempt, as some do, to deduct the full cost of your home! That would be an excellent way to beg for an audit.

We can move on to charitable deductions, another source of fine pickings for the auditor. Claiming large charitable deductions, or outrageous ones, can cause the IRS to pay special attention to your report. This is specially the case, once more, if the deduction appears out of proportion with your income. Remember: the amount of your deduction based on your income is averaged by the IRS. Any amount that falls well outside the average is deemed suspicious and up goes the red flag. If you do make an unusually large charitable contribution, it is prescient to substantiate it: attach a copy of the bill or receipt to your return, and be sure to not the dollar amount and the name of the schedule.

Here are a few more things you should remember and a few others you should know. If you donate valuable property of one sort or another, make sure to get an appraisal. Also, do not forget to file Form 8283 if your contributions exceed $500, although you may consider filing the form even if your donations fall below that amount. It is wise to hold on to any supporting documentation for the transaction such as receipts although, as mentioned above, a receipt of thanks listing the amount is usually acceptable. You should know that no deductions are allowed for body parts or, it stands to reason, quotidian trips to the blood bank would make for superb deductions. This said, it is advisable to check first with the receiving institution, hospital, etc to which you’re bequeathing that organ you no longer need: the rules may have changed in the interim. Generally, the cost of surgery and the mileage posted traveling to get it done may be deductible. Clearly, the IRS may not look kindly on your decision to have your kidney removal coincide with a trip to Hawaii when the operation could easily have been performed at a clinic near you.

Much of this is commonsensical and could all be wrapped into a final, one easier said than done surely, which is to:

Tip 7: Understand your deductions as well as your credits

Take for example the one related to medical expenses. Most people do not understand that you cannot claim all of your medical expenses as a deduction. You can only deduct the 7½% above your adjusted gross income.

Bearing greater understanding, you can always take your chances with the IRS, at worse losing the deduction and being compelled to repay all arrears with interest and fees. You could also, although we certainly do not advocate it, take up the issue in court. This is precisely what our aforementioned stripper did. Now that we have your attention again… it is enough to say that having undergone breast augmentation, allowing her to go from an elegant B cup to an all-encompassing double D, she understandably, if not wisely perhaps, chose to deduct the cost of her implants as a business expense. Her claim, initially rejected by the IRS as outrageous, was later allowed in court on the basis that it – rightly, we guess – increased her income, proof if ever that when it comes to tax things are constantly evolving.

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