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July, 2010 Tax Tip

Factors That Increase Your IRS  Audit Potential

More and more taxpayers are being audited as the IRS is under pressure to collect every tax dollar possible.  While the IRS formula for selecting returns for audit is top secret, there is little doubt aboutwhat some of those factors may be.

 Very high salary

The higher your income, the more difficult it is to fly under the radar of the IRS audit gun.  The more money you earn, the higher the chance that there is a mistake in your income, and the more valuable that error or omission is to the IRS.  It is true that taxpayers with six-figure salaries have more sources of income in their returns, such as businesses, rental properties, and investments and, therefore, have more complexities. Some refer to this as the IRS “deep pocket” theory.

Unusually high expenses or deductions

Large expenses is another factor that can place a tax return under the IRS microscope.  When my client has large expenses that could be challenged, I include an explanation in the return as to why the amounts were appropriate under the circumstances.  This is particularly true of certain business expenses, casualty losses, and contributions.  See charitable donations, below, regarding the latter.  This explanation could prevent an audit.

Appearance of the return

Don’t underestimate this factor.  A carelessly prepared return that is incomplete or hard to read invites closer inspection.  Think of your return as a house you are trying to sell.  If the outside looks like it hasn’t been cared for in months, a similar conclusion can probably be drawn as to the inside.  A return prepared by a competent professional on the computer using quality tax software eliminates the possibility that a number or description is illegible; and the software contains diagnostics alerting the preparer to possible errors  and omissions.  You can have a sloppy home if you wish, but a tax return must be neat.

Charitable donations

Charitable donations have come under much more scrutiny in recent years due, in large part, by new IRS rules that came into effect in 2007.    Regardless of the amount, the rules require that the donor maintain a record (such as a cancelled check or written communication from the charity.  In addition, you must establish that donated clothing and household items were in “good used condition or better”.  Any non-cash gift over $5,000 requires an appraisal.

Home office deduction

Self employment business deductions are potential bonanzas for the IRS.  If it appears to an auditor that you may be covering personal expenses with improper home office deductions, he or she may challenge this business practice.  My advice is to be as accurate as possible in estimating the square footage of the home office and of the entire residence.  Also, you should maintain detailed and organized receipts of the expenses included in the home office allocation.

“Mixed use” property expenses

Due to the proliferation of cell phones and computers, the IRS is onto the fact that there is much abuse in the area of mixed use property.  As the name suggests, this is property that, by its nature, lends itself to business and non-business use.  Automobiles should also be included in this list.  While good documentation of business use is essential for a taxpayer to prevail in this area, the IRS knows that many, if not most,  taxpayers fall far short in compliance.  The reason is that the requirement to maintain contemporaneous records of business use are so stringent that people don’t want to be bothered with it.  The IRS also knows that these are large deductions for any business.  Therefore, as with home offices, the word here is detailed and organized records.

Use of estimates

Let’s suppose  the IRS person responsible for selecting returns for audit is considering two returns, one of which will be selected.   In the first return the deductions for various expenses are $3,000, $5,000, $7,500, and $10,000.  In the second return the deductions are $3,127, $4,962, $$7,447, and $9,872.  All other things being equal, which return would you select for examination?  Well, if you said the first return, you would be correct, but you wouldn’t be my client.  A return that smacks of estimates (lots of zeroes) is an open house for auditors.  In the extremely unlikely event that the amounts on the first return were, in fact the actual amounts there should be no problem, right?  The return would still be selected.  Do you want that hassle?  I am not suggesting that a few amounts like $100 or $1,000 should be changed, especially if they are correct.  All I’m suggesting is that you give yourself a fighting chance.



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