No one likes paying taxes, but even more unpalatable than your annual tax bill is the threat of an audit – a process that can be time-consuming, intimidating and expensive. Your chance of being audited is small, but existent. In recent years, 1 out of nearly every 175 personal income tax returns is selected for audit.
Because the IRS does not have the resources to scrutinize the accuracy of each return, paying income taxes in the United States is based on the honor system. To keep taxpayers honest, the IRS elects to randomly audit some returns. But even truthful taxpayers get caught in the audit net. It's wise to know what issues will raise a red flag on your tax return, marking it for potential audit.
The IRS computers automatically select returns to audit each year. The program assigns a certain tax score, called a DIF (discriminating function) to each income tax return. The higher the score, the more likely is your chance of being audited.
Below are several categories that may draw the attention of the IRS. If your situation fits into one of these categories – by all means, take every deduction you are entitled to but be certain that you have all the documentation you need to back up your claims. Keep copies of these proofs in the same file as your tax return for easy access.
• Schedule C- When you are your own boss, the IRS sees greater potential to hide income, so Schedule C filers are more frequently audited. Keep accurate, neat records.
• Consistent losses- Taking home business losses year after year prompts the IRS auditors to view your business as an illegal tax break, not a legitimate business. Be ready to document your intent to earn money, even if you are not.
• Home Office deduction- This deduction attracts auditors' attention since it is so frequently taken in error. Be sure to review the specific criteria that will allow you to take this attractive deduction.
• Charitable deductions- Request and file receipts for all donations. And be aware that cash donations to different organizations fall into different deduction categories. For example, you may be able to deduct 100 percent of your donation to your local religious congregation, but only 50 percent of your donation to a political candidate.
• Unusual deductions- Remember to file Form 8275 for any rare deductions. Consider attaching a copy of your proof to your return.
• Married filing separately- If you file your taxes separately from your spouse, consult a tax advisor to be certain which deductions are permitted on which return.
• Frequent job changes- If you've had a transition year with several jobs, your return will attract more attention than those with only one or two income sources.
• Filing an Estate Tax return- This type of return is often audited.
• Undocumented income- If your lifestyle exceeds your income, you can bet the IRS will question why.
Keep in mind that mathematical errors and omissions, even unsigned returns, raise eyebrows at the IRS and you will be more likely to receive an audit. The best way to avoid a tax audit is to be honest, report all income and have a receipt for every deduction that you take. If you file a fraudulent tax form, the IRS can audit you whenever they want, even decades later.
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