How to avoid IRS audit

Now, don’t get me wrong: the truth is that there’s no sure way to avoid an IRS audit. However, there are some red flags that can shield you from unwanted attention from the IRS.

I have seen a lot of people freak out every April. The problem? Taxes! As a matter of fact, I knew a lot of Americans who would rather have root canal surgery than an Internal Revenue Service (IRS) audit. They are not entirely wrong. I mean, we hear the stories all the time from relatives, neighbors, friends or friends of friends, and even wealthy politicians and celebrities getting caught up with the tax man for not reporting, inaccurate reporting or  underreporting their incomes on their tax returns. When things like this happens, the people involved either pay stiff penalties to the IRS or are sent to jail over bad tax reporting. And if the people affected this way are celebrities, politicians or wealthy people, it can become a major news that instills fears over an IRS  agent showing up on our own doorstep. Ideally, that’s exactly how the IRS wants it: fear increases compliance. But, in spite of that, the agency doesn’t really want to put people in jail for the simple reason that they benefit more when taxpayers are out there working and bringing in more revenue.

I still remember the day I came back from work and saw a thick white envelope from the IRS in my mailbox. At first I was too scared to open it. Jesus H. Christ! What have I done this time? Am I being audited? Later on, I tied my courage to the post and opened it. It wasn’t that bad: it was about a little money I made from winning a second position in a national essay in 2014. I forgot to report this income in my tax return and the letter stated that I owed taxes on that income plus the penalty that was applied. Not a big deal: I made a payment arrangement with IRS and paid it off. End of story.

But for some people, it could be too bad. Even the legendary mob boss Alfonse Capone was sent to jail for tax evasion.¹ So it is not surprising that a lot of people get heart palpations whenever they receive a letter from the IRS. One thing is for certain: whatever your tax problems, don’t be scared. There will  always be a safe resolution provided that you are willing to work with IRS to meet their deadlines. It is important, though, to understand why IRS may be interested in eyeballing your tax return.

4 Big IRS red flags that could lead to tax audit

Without putting it in so many words, the only reason to worry about IRS audit is if you are fudging on your taxes or if you are not paying your taxes. The IRS is short on personnel and funding and, as a result, they audited only 0.86% of all individual returns in 2014.²  In 2015, they audited about 0.84% of returns while in 2016 IRS audited only 0.70% of all individual tax returns.³ So, as you can see, the chances that your return will be singled out for review is pretty low. While there’s no sure way to avoid an IRS audit, the following red flags may attract them to you.

If you make a lot of money

Generally speaking, the overall individual audit rate is only about one in 143 tax returns. However, your chances of attracting IRS examination of your tax returns increase dramatically as your income goes up. According to IRS statistics for 2016, if your income is $200,000 per year or higher, then your chances of being audited by the IRS is 1.01%, or about one out of every 60 returns; and  you have a roughly 1 in 5 chance of getting audited if you earn $10 million or more(see table 1).⁴ Now, I’m not trying to discourage you from making more money.

Table 1: Percentage of Individual Returns Audited in 2016

Size of Adjusted Gross Income	Returns Audited
No adjusted gross income	3.25%
Under $25,000	0.80%
$25,000 - $49,999	0.49%
$50,000 - $74,999	0.41%
$75,000 - $99,999	0.52%
$100,000 - $199,999	0.62%
$200,000 - $499,999	1.01%
$500,000 - $999,999	2.06%
$1,000,000 - $4,999,999	4.60%
$5,000,000 - $9,999,999	10.46%
10,000,000 or more	18.79%

Source: Internal Revenue Service Data Book, 2016

Like everyone else, you definitely want to be rich. But it is important to understand that you are more likely to hear from IRS if more income shows up in your tax return.

Failure to report all income on tax return

You are required by law to report all the income you earned in a given year to the IRS on an annual tax return. In any case, the IRS also receive copies of all of the 1099s and W-2s that you receive so don’t think you can outsmart them. So you can imagine what would happen if you did not report all required income in your return. Now, because the IRS computers are very good at matching the numbers on the forms with the income shown on your return, any mismatch will immediately light up a red flag. And this will cause the IRS computers to spit out a bill.⁵  If, for some reason you receive a 1099 listing incorrect income, or a 1099 that shows income that isn’t yours, contact the issuer immediately and get them to file a correct form to the IRS. This way you can avoid unnecessary headaches and penalties.

Are your tax deductions too big?

You could be flirting with IRS audit if the deductions on your return are disproportionately large compared with an income. Here’s a better way of putting this: if you are claiming out sized deductions it will raise red flags and the IRS may pull your return for review. So be sure to have the proper documentation for your deductions. If you do this, then you shouldn’t be afraid to claim them.

If you are running a small business

Most small business owners and self-employed individuals know that Schedule C is a treasure trove of tax deductions. But what a lot of them don’t know is that Schedule C is also a gold mine for the IRS agents. It is important to state here that IRS agents are very smart people, and they know from experience that self-employed people sometimes claim excessive deductions and don’t report all their incomes. The IRS agents are like the ‘middle school principal’  that watches over  both the higher-grossing sole proprietorship and smaller ones.

Some businesses are called cash-intensive businesses because they receive significant amount of their incomes in cash. Good examples are taxis, restaurants, hair salons, car washes, bars, and so on.⁶ If you own that type of business you will receive special scrutiny from IRS especially if you report a substantial net loss on Schedule C.

Each to their own

Next time you get those envelopes, don’t get scared. Just stay calm and remember there’s always a safe resolution. And as a taxpayer you have your rights. Take a deep breath and know that you don’t have to fear being bullied or confused by the IRS. Keep in mind that you can get some help if you need it. For example, Taxpayer Advocate is an independent organization within the IRS that have vowed to help taxpayers like you resolve their tax problems.

References

¹Crime lord Al Capone, Known As Scarface, is Found Guilty for Tax Evasion in 1931. (2016, October 17). New York Daily News. Retrieved April 24, 2017 from http://www.nydailynews.com/news/crime/crime-lord-al-capone-found-guilty-tax-evasion-1931-article-1.2833965

²Tax Debt Help(2015). IRS Audit Statistics: Rates and Chances of Receiving A Tax Audit. Retrieved April 25, 2017 from http://www.taxdebthelp.com/tax-problems/tax-audit/irs-audit-statistics

³Taylor J.(2017). 17 Red Flags for IRS Auditors. Kiplinger. Retrieved April 25, 2017 from http://www.kiplinger.com/slideshow/taxes/T056-S011-red-flags-that-can-raise-your-irs-audit-risk/index.html

⁴Bell K.(2017). 2017 Tax Guide. Bank Rate. Retrieved April 25, 2017 from http://www.bankrate.com/finance/taxes/red-flags-that-tempt-the-tax-auditor-1.aspx

⁵Taylor, op. cit., para. 3

⁶Internal Revenue Service(n. d.). Cash Intensive Business Audit Techniques. Retrieved April 26, 2017 from https://www.irs.gov/pub/irs-utl/cashchapter1_210627.pdf