5 WAYS TO AVOID AN AUDIT

Whether you’re facing an audit or simply want to avoid one, here are steps to take to deflect attention or get you prepared.

Why me? You just got the invitation to a “party” that you hoped you'd never attend — an IRS audit.

How did this happen and how can you prevent it from happening again? We’ll get to the how when we answer how to minimize the chances of an audit and how to survive one.

Rule 1: Check Your Arithmetic

Few audits are generated by mathematical mistakes alone. The Internal Revenue Service computers automatically correct both mathematical errors and mistakes where you have claimed deductions that exceed limits set by the tax code itself, such as the 7.5% adjusted gross income limitation on medical deductions. However, too many of these kinds of errors indicate a sloppy return, and that that may lead to a full audit.

While it may seem obvious, let’s not give the IRS any additional reasons to look at your return.

But how do you get picked?

The IRS has a computer program that compares your deductions to others in your income bracket and weighs the differences. This secret IRS formula, called the DIF Score, is used to select returns with the highest probability of generating additional audit revenue.

For example, a taxpayer with a $50,000 salary would rarely have $10,000 in charitable contributions. This doesn’t mean that, if you have only $50,000 in income and actually have $10,000 in charitable contributions, you shouldn’t claim those deductions. It only means that if that is the case, be prepared to prove those deductions. The DIF formula considers not only your income and deductions, but where you live, the size of your family and your profession as well. Rarely will a family of five living in the Polo Grounds have an income of $30,000 or less. It may happen, but if it does, the IRS will want to know how. This leads to . . .

Rule 2: Arrange Your Finances So You Don’t Stand Out

If you think you may be audited, see if your situation is likely to attract the tax man’s attention. Here are groups that often do invite inquiries:

The self-employed. If you are self-employed, you have more opportunity to either “hide” your income or “create” deductions by converting personal expenses into business expenses. If so, be prepared to substantiate your expenditures as deductible expenses. The IRS is aware of the myriad “business vehicles” that go away to college every September, and the probability of your being audited is enhanced.

“High” personal income individuals. For fiscal year 2002, the IRS audited 0.86% of the filers who had income of $100,000 or more. Only 0.57% of all individual income tax returns filed were audited. About 0.16% of all individual returns were examined by field audits, where the IRS comes to your home or place of business.

Those who largely get their income in cash. The IRS has specific audit programs aimed at specific professions and occupations. Because they receive much of their income in cash, people who work in the gaming industry, waiters, accountants and even doctors are prime audit targets. The more cash you receive and the higher your income potential, the more likely the IRS is to find additional tax dollars by reviewing your return.

Those who engage in potentially abusive activities. There are a number of kinds of areas of potential abuse that attracts the IRS. For fiscal 2003, the IRS declared that it was specifically targeting these areas for audit:

Rule 3: Substantiate, Substantiate, Substantiate

In the audit itself, the IRS will focus on those items where taxpayers have historically failed to keep the required substantiation. Traditionally, auto, travel, meals and entertainment have been the areas most audited. To deduct auto expenses, you must establish the percentage of business use as well as the actual expenses incurred. I ask my clients to keep a mini-cassette recorder in their cars to record the business mileage and purpose. Kept contemporaneously, it is acceptable as sufficient substantiation of business use. Alternatively, a written diary of miles used for business would also be accepted.

You must have a receipt for all individual expenditures of $75 or more for meals and entertainment. The rule is simple: no receipt, no deduction. If the expense is less than $75, a diary notation is sufficient. However, both the receipt and the diary notation must have all of the following information:

Unless you talk business, before, during or after the meal or entertainment, your deduction won’t be allowed. Remember, with the IRS, paper rules! With any and all expenses, deductions will be more easily allowed if you have a piece of paper to back them up.

Here’s another piece of advice: Don’t come in with a carton of miscellaneous receipts. The more “organized” your receipts and the more paper you produce, the easier it is for an IRS agent to conclude that you are organized, have full substantiation and owe no additional taxes.

One more point about how you’re selected for an audit. The IRS computer selects many returns for audit on a random basis. Your income, deductions or where you live are irrelevant. Your number just came up — you won the audit lottery. A student making $3,000 a year is just as likely to be selected as an accountant making $300,000. You just got “lucky.”

The IRS can audit you for three years after you file your return. In reality, however, most returns are audited within 18 months of filing. This gives the IRS time to do the review and request the appropriate substantiation before the statute of limitations (usually the three-year period) ends. Once the statute has run out, the IRS normally cannot audit your return, and your expenses are insulated from examination. It has been claimed that the later in the year you file (see Rule 4 below), the less likely it is the IRS will pick your return to be examined. The IRS still insists that agents are not graded or evaluated on the amount of money they collect until — surprise! — Congressional testimony reveals that policy is not the same as practice.

Real suprise! In March 2003, the Treasury Inspector General concluded that the IRS was “generally in compliance” with the restrictions on using enforcement statistics to evaluate employee performance. This directly contradicts the sworn testimony of Treasury and IRS employees before Congress. Who do you think is telling the truth?

Rule 4: Know When to File

I recommend that you have your return prepared early. If you have a big refund and are unconcerned with audit issues, file early and get your money back. If you have taxes due, and no penalty for underpayment, don’t file until April 15. Don’t ever pay a federal tax bill before it is due. It’s an interest-free loan to the IRS.

On the other hand, if you are concerned about a potential audit, never file until the last minute. It won’t hurt and can only decrease your chances of being selected.

Along the same line, your return should be filed on time. But there is a Catch-22. Your return by law must also be true, complete, and accurate. If you need more time to substantiate your income and deductions, by all means use extensions to get more time. (Read the accompanying article on this web site Stretched for time? Get an extension!). IRS denies, but statistics prove, that the later you file in the year, the smaller the probability that your return will be selected for audit. FACT!

Rule 5: Plan Your Taxes to Preëmpt an Audit

I highly recommend the use of pre-audit strategies. If, say, you have a huge medical deduction for a year that you feel would increase your chances of being audited, attach copies of your medical bills to your return.

Alternatively, if you made an unusually large charitable contribution, attach a copy of the check or receipts to your return. The IRS computer will still kick out your return, but when a real person looks at it, the reviewer will recognize that you know the rules. It may actually reduce your odds of a full audit.