Few words set off alarm bells like the word “audit.” The good news is there are ways to reduce the likelihood the Internal Revenue Service will tag you for an audit. But if a letter from the IRS does appear in your mailbox, don't panic.
The IRS audits only about 1 percent of taxpayers with incomes under $200,000, according to the tax experts at the Pennsylvania Institute of Certified Public Accountants. Certain red flags raise the likelihood that you'll be audited, so here are some things you should try to avoid:
The biggest reason people receive letters from the IRS is simple addition or subtraction mistakes. Math errors rarely lead to a full audit, but you should still check your math before you send your return.
If you get a W-2, you probably won't have to worry about income statements that don't match. But if you get 1099s, get paid in cash or have additional income from other sources, make sure the amount you declare matches what the IRS has received from other sources. Other inconsistencies can also attract attention, such as if your last name isn't the same throughout your paperwork or if you transpose a couple of numbers in a Social Security number.
Unrealistically low income
Making a lot less money than someone else in your same profession may raise eyebrows at the IRS.
Making a lot of money
Statistics show that if you make more than $200,000 a year, you're more likely to be audited.
Big charitable deductions
Charitable donations are a legitimate deduction, but recognize that if you are very generous, you should be prepared to have the documentation to support your generosity. Charity deductions in the 1 percent to 3 percent range are typical, but larger deductions may trigger an audit. Be sure to have receipts from the charity as well as records of appraisals of property that was donated among other things.
Home office deduction
If you qualify for a home office deduction, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance and other costs that are properly allocated to the home office. You must, however, use the space exclusively and regularly as your principal place of business. "Exclusive use" means that a specific area of the home is only for trade or business, not also for the family to watch TV at night.
Claiming 100 percent business use for vehicles
As with home offices, the IRS is skeptical about claims that you never drive a work vehicle for personal reasons.
Claiming rental losses
The IRS is scrutinizing rental real estate losses, especially those written off by taxpayers claiming to be real estate professionals. The IRS will check to see whether the necessary hours have been worked, especially in cases of landlords whose day jobs are not in the real estate business.
Failing to report a foreign bank account
Failure to report a foreign bank account can lead to severe penalties, and the IRS has made this issue a top priority. Make sure that if you have any such accounts, you properly report them when you file your return.
Other red flags
• Cash businesses draw scrutiny, especially if the return also includes an earned income tax credit.
• Self-employed people claiming meals, travel or entertainment expenses on their Schedule C.
• Deductions for hobby-related activities on a Schedule C.
If an audit is inevitable
If the IRS does contact you, knowing what to do will help put your mind at ease.
Remember, you are entitled to ask why you are being audited. Stay calm, contact the IRS and respond to all requests from the agency in a timely fashion.
Here are some suggestions if you need to prepare for an audit:
• Understand the details. There are three primary types of audits: correspondence audit, office audit and field audit.
A correspondence audit is handled entirely by mail. The IRS seeks supporting documentation for an item on your return.
An office audit is at a nearby IRS office. The IRS will review a few items on your return.
A field audit takes place at your home or business. There will be a thorough review of items on your return.
• Prepare a response. When the IRS sends you a letter, don't ignore it. Prepare a written response. If you need more time to gather information, ask for it.
• Organize your documents. Once you know what is expected of you, start going through your records to find the necessary receipts and documents. Never send in your original documents or your only copy.
• Don't overshare. Never send in more information than is requested. Send what the IRS requests. Period.
A CPA can help
Taxpayers can certainly attempt to navigate an IRS audit on their own, but placing a call to a CPA for help may be a good idea. Undergoing an IRS audit can be stressful. A CPA can help guide you through the process, ensure that you're meeting all of your legal obligations and act as your representative to meet with an IRS examiner. The important thing is to call for help before you get in over your head.
For more information about Pennsylvania Institute of Certified Public Accountants (PICPA), visit www.ineedacpa.org.