Every April, we file our tax returns, and every year, the Internal Revenue Service audits some of us. On average, you have a 1 in 200 chance of being audited; the odds go up to 1 in 100 if you make in excess of $100,000 per year. Those odds might not sound great, but they're actually getting better, as the IRS has been forced to reduce its staff.
That being said, there are certain things that just scream, "Audit me!" Here are some of those red flags and tips to keep from drawing attention to your return.
1- Your income doesn't match your lifestyle or zip code.
One of the fastest ways to red flag a return is for the IRS computers to reference your reported income against your zip code. In about the same amount of time, the IRS will also compare your declared income for the year against your return from last year (a sizeable drop could mean that you're hiding money), and look for a huge difference between your expenses (e.g. a huge mortgage -- assuming you deducted the interest) and your income.While there is no way to avoid this kind of scrutiny, you should take comfort in the fact that the IRS isn't looking for minor variances. However, guys who insist that they support a family of five and own a home in a posh neighborhood, all on $20,000 a year, will have some explaining to do.
2- You employ family members.
Hiring family members isn't illegal. But employing more than your immediate family could raise the red flag at the IRS. Why? Well, for every legitimate family business, there are plenty of guys who make their family members "employees" as a way to distribute money to loved ones while lowering their own tax liability. If you run a family business, don't be tempted to pay relatives who don't work for you (although you can give them a gift, if you like) and be sure to keep accurate payroll records.3- You have little or no tax liability because of a trust.
Trusts that minimize tax liability are perfectly legal. But some guys raise red flags at the IRS when they lower their tax liability down to zero. Usually, trust schemes that promise little or no tax liability aren't legitimate trusts at all. The IRS calls them sham trusts because, unlike a real trust, the beneficiary retains control of the money. In other words, these are elaborate schemes sold by crooked CPAs and lawyers that, in the end, aren't much different from a checking account. Such "trusts" fall under the category of too good to be true and are best avoided.4- You earn a lot of your money in cash.
It may not be fair, but the IRS assumes that if you are in a profession that is regularly paid in cash, you are going to cheat. In truth, the IRS assumes we all cheat, but for those on payroll, there is a record. If you work in a cash industry, know that every return you file could raise a red flag, especially if you're a high-income cash earner. Keep good records and remember that if you declare home-office deductions, you'll be in for extra scrutiny. Accordingly, high-income cash earners should seek professional tax preparation advice.5- Your alimony payments don't add up.
IRS computers easily cross-reference alimony payments. If you're receiving alimony, you'll need to report it as income. If you're paying alimony, you should check with your tax advisor about when and if you can take a deduction on that money. But remember: If both returns don't match up, you and your ex could both raise red flags, so make sure the both of you are on the same page. True, she may not be your favorite person, but neither one of you wants an audit.6- Your deductions far exceed your income.
For a lot of guys, their primary goal in April is to declare all the deductions they can get away with. And while that's often sound advice, you can go too far -- especially if you're trying to avoid raising a red flag. While there are no hard numbers on deductions versus income, it's best to use common sense. Look at your return and ask yourself if it looks extreme. If the answer is yes, you'll likely raise a red flag.And watch out for deductions on your business vehicle. This is a common area where self-employed men get into trouble by making aggressive deductions. Keep a log of your business driving and only deduct the mileage, and don't even think about calling your son's car a business expense if you're already pushing the deduction envelope.
7- You have high schedule C losses for a part-time business.
It's okay to lose money, and there's no rule on how many years you can stay in the red without raising a red flag (although more than a few years could raise some eyebrows). What will attract unwanted attention are high losses on your schedule C that make you look like you're living the good life without any real income at the end of the year.If that's you, you run the risk of the IRS reclassifying your business into a hobby (and of having to pay taxes at the higher rate). To keep this from happening, you'll need to show that you expect to make a profit in the future, that you have the skills/training to make it happen, that the money and time you spend is with the intent to make the business work, and that you generally carry out your business affairs in a professional manner.
8- You have income from abroad.
Some guys make the mistake of thinking that because they work overseas, either for a foreign or American firm, they are not subject to U.S. taxes. In fact, unless they have met the appropriate non-residency qualifications, all U.S. citizens are taxed based on income earned worldwide. However, earning a sizeable chunk of your money abroad can raise red flags because there is often no way for the IRS to determine the total amount or source of the money.tips to avoid an audit
While we don't recommend that you try to put one past the IRS, here are some tips to help you from drawing unwanted attention to your return.File on time.
The goal is to file right when everyone else does -- not late, but not early. Ideally, you'll be lost in the masses.Show the IRS that you know the rules.
Sometimes you have a financial year that is more likely to trigger an audit. In that case, you could attach copies of supporting documents to your return. It means a hand review, but it also shows the IRS that you're not trying to pull a fast one.Submit a neat return.
A sloppy return filled with errors will be rejected by the IRS computers, which means a human will have to inspect it.don't get flagged
An audit isn't the end of the world, but it is the start of an unpleasant and often costly experience. Employing these precautions will help you limit the chances of an audit, but if you're breaking the rules, no easy tips can get you of trouble. Remember: You can certainly try to beat the IRS, but if you get caught, the penalties can be severe.Resources:
http://www.salary.com/money/layoutscripts/mnyl_display.asp?tab=mny&cat=nocat&ser=Ser62&part=Par134
http://www.selfemployedweb.com/avoid-irs-tax-audit.htm
http://www.powerhomebiz.com/vol55/taxaudit.htm
http://moneycentral.msn.com/content/Taxes/Avoidanaudit/P34106.asp
http://www.freemoneyfinance.com/2006/01/eight_ways_to_a.html
http://www.boston.com/business/taxes/articles/macpa/new_2006/Taxaudittriggers/
http://www.irs.gov/faqs/faq13-7.html
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