Audit Avoidance 101: Warding off a Visit from the IRS

No one wants to be audited. It's an experience that ranks up there with having a root canal or running into your ex and his new bride when you're sporting twenty extra pounds and a bad perm. But if you live long enough and earn a healthy income, it could very well happen to you. Still, there are ways to reduce your chances of an indigestion-inducing visit with an IRS agent.

"Although no one is exempt from the 'audit lottery,' there are certain things you can do to make it less likely that you'll be selected for that dubious honor," says financial counselor and best-selling author Eric Tyson. "Some of them fall into the commonsense arena, like double-checking for mistakes. Others seem inadvisable, like earning less money. But together, they provide something of a 'cloak of invisibility,' albeit a less-than-fool-proof one, to hide you from the roving eyes of the IRS."

In the new book Taxes 2005 For Dummies (Wiley, 2005, ISBN: 0-7645-7211-3, $16.95), Tyson and co-authors David J. Silverman, EA, and Margaret Atkins Munro, EA, offer the following tips:

Double-check your return for accuracy

Audit your own return before you send it in. If the IRS finds mistakes through its increasingly sophisticated computer-checking equipment, you're more likely to be audited. They figure that if they find obvious errors, some not-so-obvious ones lurk beneath the surface.

Have you included all your income? Think about the different accounts you had during the tax year. Do you have interest and dividend statements for all your accounts? Finding these statements is easier if you've been keeping your financial records in one place. Check your W-2s and 1099s against your tax form to make sure that you wrote the numbers down correctly.

Don't forget to check your math. Have you added, subtracted, multiplied, and divided correctly? Are your Social Security number and address correct on the return? Did you sign and date your return?

Such infractions won't, on their own, trigger an audit. In some cases, the IRS simply writes you a letter requesting your signature or the additional tax you owe (if the math mistake isn't too fishy or big). In some rare instances, the IRS even sends a refund if the mistake it uncovers is in the taxpayer's favor—really! Regardless of how the IRS handles the mistake, it can be a headache for you to clear up, and, more important, it can cost you extra money.

Declare all your income

When you prepare your return, you may be tempted to shave off a little of that consulting income you received. Who will miss it, right? The IRS, that's who. Thanks largely to computer cross-checking, the IRS has many ways of finding unreported income. Be particularly careful if you're self-employed; anyone who pays you more than $600 in a year is required to file a Form 1099, which basically tells the IRS how much you received.

When you knowingly hide income, you face substantial penalties, and, depending on the amount, criminal prosecution. That wouldn't be a picnic, especially if you can't afford to hire a good defense attorney.

Don't itemize

People who itemize their deductions on Schedule A are far more likely to be audited because they have more opportunity and temptation to cheat. By all means, if you can legally claim more total deductions by using Schedule A than you can with the standard deduction, we say "itemize, itemize, itemize." Just don't try to artificially inflate your deductions.

On the other hand, if it's basically a toss-up between Schedule A and your standard deduction, taking the standard deduction is safer, and the IRS can't challenge it.

Earn less money

At first glance, earning less money may seem like an odd suggestion, but there really are costs associated with affluence. One of the costs of a high income—besides higher taxes—is a dramatic increase in the probability of being audited. If your income is more than $100,000, you have about a one in twenty chance each year of being audited. But your chance is less than one in one hundred if your income is less than $50,000. You see, there are advantages to earning less!

If you manage to pile up a lot of assets and don't enjoy them in retirement, your estate tax return—your final tax return—is at great risk of being audited. Do you think a one in twenty or one in one hundred chance is bad in the audit lottery? Uncle Sam audits more than one in seven estate tax returns. Nearly half of estate tax returns for estates valued at more than $5 million are audited because big bucks are at stake. The IRS collects an average of more than $100,000 for each estate tax return it audits! So enjoy your money while you're alive or pass it along to your heirs in the here and now—otherwise, your heirs may have trouble getting it in the there and later!

Don't cheat

It may have taken the IRS a while to wise up, but now the government is methodically figuring out the different ways that people cheat. The next step for the IRS—after they figure out how people cheat—is to come up with ways to catch the cheaters. Cheaters beware!

The IRS also offers rewards for informants. If you're brazen enough to cheat and the IRS doesn't catch you, you may not be home-free yet. Someone else may turn you in. So be honest—not only because it's the right thing to do but also because you'll probably sleep better at night knowing that you aren't breaking the law.

Tax protestors, take note. The IRS may flag returns that are accompanied by protest notes. Threats are bad, too—even if they're meant in fun (humor isn't rife at the IRS, we suspect). The commandment to follow is: Thou shalt not draw attention to thyself. The protest issue is interesting. During congressional hearings, tax protestors stand up and tell members of Congress that the income tax is unconstitutional. They say they have proof. If we can get our hands on the proof, we'll include it in the next edition of the book. In the meantime, pay your taxes and resist the temptation to send along a cranky letter with your tax returns and payments. To read the IRS's take on the typical tax protester's arguments, point your Web browser to www.irs.gov/pub/irs-utl/friv.tax.pdf for fifty-four action-packed pages, including legal citations.

Stay away from back-street refund mills

Although this advice doesn't apply to the majority of tax-preparation firms, unfortunately, some firms out there fabricate deductions. Run away—as fast as you can—from tax preparers who tell you, after winking, that they have creative ways to reduce your tax bill, or those who base their fees on how many tax dollars they can save you. Also beware of any preparer who promises you a refund without first thoroughly reviewing your situation.

Be careful with hobby losses

Some people who have full-time jobs also have sideline businesses or hobbies with which they try to make a few bucks. But be careful if you report the avocation as showing a loss year after year on your tax forms. Filers of Schedule C, Profit or Loss from Business, are at greatest risk for audits.

Here's an example. You like to paint surreal pictures, and you even sold one in 2001 for $150. But since then, you haven't sold any paintings (the surreal market has faded). Nevertheless, you continue to write off your cost for canvas and paint. The IRS will take a close look at that record, and you may be a candidate for an audit.

Don't be a nonfiler

The IRS has a special project with a mission to go after the estimated 5 million or more nonfilers. Lest you think that the IRS does things in small ways, the IRS assigned hundreds of agents to the project. Again, when you get caught—which is just a matter of time—in addition to owing back taxes, interest, and big penalties, you may also face criminal prosecution and end up serving time in the slammer. So keep a clear conscience, continue to enjoy your freedom, and file your tax returns. And remember, better late than never!

Don't cut corners if you're self-employed

People who are self-employed have more opportunities to make mistakes on their taxes—or to creatively take deductions—than company payroll wage earners. As a business owner, you're responsible for self-reporting not only your income but also your expenses. You have to be even more honest when dealing with the tax authorities, because the likelihood of being audited is higher than average.

Don't disguise employees as independent contractors. This maneuver is covered by another IRS project. Remember the old barb: You can't put a sign around the neck of a cow that says, "This is a horse." You don't have a horse—you have a cow with a sign around its neck. Just because you call someone an independent contractor doesn't mean that person isn't your employee.

Nothing is wrong with being self-employed. But resist the temptation to cheat because you're far more likely to be scrutinized and caught as a self-employed worker.

Carry a rabbit's foot

Try as you may to be an obedient taxpayer, you can be audited simply because of bad luck. Every year, the IRS audits some taxpayers at random. Although such an undertaking may seem like a colossal waste of time to a tax neophyte like yourself, this effort provides the IRS with valuable information about the areas of tax returns where people make the most mistakes—and about the areas where people cheat!

"If you do get an audit notice, don't assume that you did anything wrong," says Tyson. "It happens to the most well-intentioned of taxpayers. In fact, it happened to me and I lived to tell about it. Just be prepared for your audit—another subject we cover in Taxes 2005 For Dummies—and continue to do everything right in the future. It may help to remember that, like death and taxes, audits are sometimes unavoidable."

About the Authors: Eric Tyson, MBA, is an accomplished financial counselor and freelance personal finance writer. He is the author of numerous other For Dummies national bestsellers on personal finance, investing, and home buying, and is a syndicated columnist. His work has been critically acclaimed in hundreds of publications and programs, including Newsweek, The Los Angeles Times, The Chicago Tribune, Kiplinger's Personal Finance Magazine, The Wall Street Journal, Bottom Line Personal, as well as NBC's The Today Show, CNBC, PBS's Nightly Business Report, CNN, FOX-TV, CBS national radio, Bloomberg Business Radio, and Business Radio Network. His radio commentaries can be heard on the nationally syndicated public radio Sound Money program. Eric is a former management consultant and holds an M.B.A. from the Stanford Graduate School of Business.

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