How Does IRS pick a Tax Return for Audit? IRS has automated processes to scan tax returns. First there are some basic data verification checks that the computer performs such as checking the name, social security number, W2 information etc. Next the IRS computers assign a rating to each tax return based on audit triggers from the statistical analysis of every item on the tax return and correlating averages found on a cross-section of past successfully audited tax returns. The exact formula is kept secret by the IRS so it is impossible to find out what triggers are being given more weight in any particular year, but the tax community monitors closely to see any new trends. After the IRS computer kicks out the audit worthy tax returns, an IRS agent will review them and make the determination to audit it or let it pass.
For a long time some accountants believed that in order to escape IRS audit, one should file a paper return with an extension. IRS claims that it treats all returns in the same way irrespective of how and when they were filed.
Five Mistakes to Avoid an IRS Audit
1) Report all sources of Income, including 1099s, 1098s
This sounds very obvious but many tax payers forget to include all of their incomes. Form 1099 includes 1099-INT for interest, 1099-DIV for dividends, 1099-G for tax refunds, 1099-R for pensions and 1099-MISC for miscellaneous income. Forms 1098 which lenders send to you and the IRS recording how much interest you paid.
Just like your W2 information, this information is received and tracked in the IRS computers. The IRS matches your return against the 1098s and 1099s. If there is a mismatch you will definitely hear from the IRS. So regardless of how many 1099s and 1098s you receive, make sure they all are accounted for on your return.
2) Math - Facts
Check your numbers through each step and do some simple math checks when you finish. Even if you use a software program, make sure you check the numbers before filing electronically. If the numbers don't add up, you will definitely get a notice from IRS. This is not an audit, but once the software kicks your return out of the automated process to an IRS agent, there is no telling what else they might uncover!
3) Schedule C - Business Losses
Schedule C is by far the biggest trigger for audits. Consistently filing losses under schedule C is likely to trigger an audit especially if main source of income continues to be W2 wages. IRS auditors go after these returns very aggressively. In order for these business losses to stand up, you must pass both the "passive loss" and "hobby loss" rules. Most tax payers are not familiar with these rules, and the IRS knows it.
Another trigger is taking earned income credit while filing schedule C. Make sure you take the proper Schedule C deductions if you have a business and especially if you make around $16,000. Also on the Schedule C a big audit flag is claiming a car for 100% business, but you don't have another car. These are simple logical catches; make sure you cover your basis.
If you have a genuine long term business, I would strongly recommend changing your business entity in to a corporation and file separate business return. Schedule C's are 10 times more likely to be audited than Partnerships, multiple member LLCs, C and S Corporations. In any case, take help of a professional tax accountant if you need to file a Business Loss or Profit.
4) Don't use Round Numbers
Too many round numbers can be a red flag to the IRS. Rounded numbers just don't happen very often in the real world. For example in Entertainment and Meals Expenses, don't use $6000 instead of $5985.
The golden rule of taxes is documentation, documentation, documentation. Keep good records of all your expenses. Several tax payers assume that maintaining accounts in a software or excel sheet is sufficient proof of their expenses. This is not true. You are required to maintain receipts or proof of payment - cancelled checks, credit card statements etc if you claim a deduction.
You don't have to forgo your right to a good tax refund for the fear of a tax audit. Just make sure you have all the documentation for the deductions that you are claiming. If you are not sure about a certain deduction, check with your tax accountant and make the final determination.
Keep in mind this column and the articles published here are only meant to provide you with high level information about taxes and in no way should you consider this as tax advice. Hopefully I have got you started thinking about saving more of your hard earned money, paying less to the IRS and at the same time reduce your immigration risks as you brave through the economic head winds in a recession. Consult your Tax Advisor regarding your individual tax situation and your immigration attorney for any immigration related situation.
This Article provides only an overview to the complex Tax Laws. It is not exhaustive nor a substitute for Independent Tax Advice provided by a Tax Accountant or a Tax Attorney familiar with your case.