Audit Flags
There aren't many things in life that make people shudder and shake their
heads in disgust, as does the mention of the IRS. Perhaps the only thing
that comes close is a visit to your in-laws.
Tax season is upon us and, unless you're a sadist, you'll want to get the
whole filing process done as quickly and painlessly as possible. Rushing
to finish the task, however, may cost you, as will oversights, omissions
and anything you wish to cover up. That's because the IRS takes note of
any curious elements in your statement, red flags them and then prepares
to audit your sorry ass.
A red flag is a warning sign the IRS puts on different elements of your tax
forms, which seem inconsistent and suspicious. It is not a scientific term of
any kind, but rather a phrase used by the IRS to designate any detail of a
tax report that seems out of the ordinary.
Fortunately, the IRS does not assign these red flags haphazardly. The
computers that file through each form look for certain criteria before they
pin you down for an audit.
As of 2001, when the latest tax statistics are available, about 1 in every
170 tax returns was fingered for an audit. This is a markedly smaller ratio
than a decade ago when 1 in every 79 forms was audited. The trend is
set to change in 2005, however, as the IRS plans to add more
enforcement (as it calls its personnel) to the payroll. As the number of
audits increase, it's important to figure out how you can avoid red flags.
Potential red flags:
Before you do anything, make sure you file with diligence, even if an
accountant or tax agency helps you out. This should be a rule of thumb to
live by.
Every figure should be analyzed with a fine-toothed comb in order to
ensure its legitimacy. This is the first step toward avoiding red flags. Any
inconsistencies, like reporting an income of $35,000 a year while you park
a BMW in a four-car garage, will pique the curiosity of the IRS.
Find out why the computer would finger you...
There are more specific warnings that the IRS looks for. In fact, it is not a
person who will initially flag your form; a computer program called the
"Discriminant Index Function," or DIF, analyzes forms first. It finds the
following aspects of your tax form the most suspicious:
1- Substantial business meal and entertainment deductions
2- Unreported income, in the form of investment returns or contract work
3- Excessively high incomes compared to the previous year
4- Large deductions relative to income
5- Excessive home office deductions
6- Losses from a hobby rather than a business venture
7- Offshore credit cards
8- Low incomes, but significant business deductions
9- Non-cash charitable deductions
10- Several dependents
Many of these suspicious signs (which represent only a few of the things
the DIF looks at) are applicable for small businesses. It is these entities
the IRS is now bent on targeting, since many deductions, such as for your
home office or a trip, are often taken advantage of. In general, red flags
are assigned to any aspect of your tax forms that seems inconsistent with
other reported figures. So, if you donated 70% of your net income to
charity or work from home, but have generous travel deductions, it will
surely catch someone's watchful eye.
Furthermore, discrepancies between different tax forms are big red flags.
For instance, if you're a contractor, you should be receiving Form 1099
from the businesses you worked for. If the earnings from these activities
do not match your income reported on Schedule C, prepare to hear from
the jolly people at the IRS.
what you can do
Be Concise & Punctual
Recall the instructions of your grade 4 teacher: Be neat, legible and
concise when filling out tax forms. Do not turn the written notes on the
forms into essays -- be concise. Also, just like in school, be punctual. A
tax return that is filed on time appeases the IRS.
Don't omit information.
At the same time, it's important to be thorough. Report all income, down to
the smallest figures. It can't hurt to do this, since an honest taxpayer
sleeps well at night. Of course, it takes time to go through all the financial
activities of the past year, but it's well worth it.
Don't round off amounts
Precision is key: instead of lumping all your expenses into a
"Miscellaneous" category, single out each expense and make it stand on
its own. Precision concerns the actual amounts as well. Many filers tend
to round off figures, quoting deductions as $1,000 instead of $997. These
numbers are considered estimates if they appear often enough and this is
a tendency the IRS doesn't like.
Keep all documents for 5 to 10 years
Finally, be responsible. Keep all tax forms and important receipts for at
least five years, preferably seven to 10. The IRS, with its new, more
aggressive auditing procedure, can go through files that date back further
than the past year. Of course, the secret to avoiding headaches is to pay
someone else to do it. An accountant will do all this work for you, ensuring
that everything is reported according to all the rules.
You did everything, but you're still getting audited. Find out why and what
you can do about it... in case of an audit...
After all this effort, you may still be targeted by the IRS. This could be a
result of its random audit selection process, called the National Research
Program, or an actual problem on your return that you overlooked. There
are three types of audits, each one more painful than the last.
1- Correspondence audit
Most taxpayers in this situation will first receive a letter informing them of
the discrepancy. If you get this letter in the mail, don't freak out. It is not
the end of the world because, most of the time, these letters simply ask
for a receipt, explanation or old form that would clear up the problem in
question.
All you have to do is supply the document to the IRS via mail and then it
will all be over. This kind of tax form inspection is called the
correspondence audit and is the least intrusive of three types of audits the
IRS conducts.
Unfortunately, sometimes receiving a letter from the IRS is out of your
control. As mentioned before, one of the potential red flags is a
high-income increase from the previous year. It very well may be that you
recently got a great job or promotion that saw a huge hike in your salary.
The IRS may be suspicious of your income and ask for more proof, even if
you made a note of this on your tax return. Respond swiftly to the
correspondence audit to quell any reservations.
2- Office audit
The second type is called an office examination. This occurs when the
problem is serious enough to necessitate a meeting between you and an
IRS worker at a local branch of the agency.
When at these meetings, bring only the documents required and be
honest. Do not flood the IRS agent with extra forms, unless you want
further problems. This may seem like a real pain, but it could be worse...
3- Field audit
That's right; you could be receiving a field examination, the third type of
audit. Here, an agent visits your business or home and does a thorough
inspection of your lifestyle. He will check out where and how you live,
what physical assets you have, as well as anything else that may provide
information as to why you reported your income the way you did.
Usually reserved for the wealthy, these audits are intrusive and
nerve-racking, to say the least.
If you follow these basic, sometimes challenging, tax filing tips, chances
are that no red flags will come up when your report is processed. This
decreases the chance of an audit and may even change your opinion of
the IRS.
There aren't many things in life that make people shudder and shake their
heads in disgust, as does the mention of the IRS. Perhaps the only thing
that comes close is a visit to your in-laws.
Tax season is upon us and, unless you're a sadist, you'll want to get the
whole filing process done as quickly and painlessly as possible. Rushing
to finish the task, however, may cost you, as will oversights, omissions
and anything you wish to cover up. That's because the IRS takes note of
any curious elements in your statement, red flags them and then prepares
to audit your sorry ass.
A red flag is a warning sign the IRS puts on different elements of your tax
forms, which seem inconsistent and suspicious. It is not a scientific term of
any kind, but rather a phrase used by the IRS to designate any detail of a
tax report that seems out of the ordinary.
Fortunately, the IRS does not assign these red flags haphazardly. The
computers that file through each form look for certain criteria before they
pin you down for an audit.
As of 2001, when the latest tax statistics are available, about 1 in every
170 tax returns was fingered for an audit. This is a markedly smaller ratio
than a decade ago when 1 in every 79 forms was audited. The trend is
set to change in 2005, however, as the IRS plans to add more
enforcement (as it calls its personnel) to the payroll. As the number of
audits increase, it's important to figure out how you can avoid red flags.
Potential red flags:
Before you do anything, make sure you file with diligence, even if an
accountant or tax agency helps you out. This should be a rule of thumb to
live by.
Every figure should be analyzed with a fine-toothed comb in order to
ensure its legitimacy. This is the first step toward avoiding red flags. Any
inconsistencies, like reporting an income of $35,000 a year while you park
a BMW in a four-car garage, will pique the curiosity of the IRS.
Find out why the computer would finger you...
There are more specific warnings that the IRS looks for. In fact, it is not a
person who will initially flag your form; a computer program called the
"Discriminant Index Function," or DIF, analyzes forms first. It finds the
following aspects of your tax form the most suspicious:
1- Substantial business meal and entertainment deductions
2- Unreported income, in the form of investment returns or contract work
3- Excessively high incomes compared to the previous year
4- Large deductions relative to income
5- Excessive home office deductions
6- Losses from a hobby rather than a business venture
7- Offshore credit cards
8- Low incomes, but significant business deductions
9- Non-cash charitable deductions
10- Several dependents
Many of these suspicious signs (which represent only a few of the things
the DIF looks at) are applicable for small businesses. It is these entities
the IRS is now bent on targeting, since many deductions, such as for your
home office or a trip, are often taken advantage of. In general, red flags
are assigned to any aspect of your tax forms that seems inconsistent with
other reported figures. So, if you donated 70% of your net income to
charity or work from home, but have generous travel deductions, it will
surely catch someone's watchful eye.
Furthermore, discrepancies between different tax forms are big red flags.
For instance, if you're a contractor, you should be receiving Form 1099
from the businesses you worked for. If the earnings from these activities
do not match your income reported on Schedule C, prepare to hear from
the jolly people at the IRS.
what you can do
Be Concise & Punctual
Recall the instructions of your grade 4 teacher: Be neat, legible and
concise when filling out tax forms. Do not turn the written notes on the
forms into essays -- be concise. Also, just like in school, be punctual. A
tax return that is filed on time appeases the IRS.
Don't omit information.
At the same time, it's important to be thorough. Report all income, down to
the smallest figures. It can't hurt to do this, since an honest taxpayer
sleeps well at night. Of course, it takes time to go through all the financial
activities of the past year, but it's well worth it.
Don't round off amounts
Precision is key: instead of lumping all your expenses into a
"Miscellaneous" category, single out each expense and make it stand on
its own. Precision concerns the actual amounts as well. Many filers tend
to round off figures, quoting deductions as $1,000 instead of $997. These
numbers are considered estimates if they appear often enough and this is
a tendency the IRS doesn't like.
Keep all documents for 5 to 10 years
Finally, be responsible. Keep all tax forms and important receipts for at
least five years, preferably seven to 10. The IRS, with its new, more
aggressive auditing procedure, can go through files that date back further
than the past year. Of course, the secret to avoiding headaches is to pay
someone else to do it. An accountant will do all this work for you, ensuring
that everything is reported according to all the rules.
You did everything, but you're still getting audited. Find out why and what
you can do about it... in case of an audit...
After all this effort, you may still be targeted by the IRS. This could be a
result of its random audit selection process, called the National Research
Program, or an actual problem on your return that you overlooked. There
are three types of audits, each one more painful than the last.
1- Correspondence audit
Most taxpayers in this situation will first receive a letter informing them of
the discrepancy. If you get this letter in the mail, don't freak out. It is not
the end of the world because, most of the time, these letters simply ask
for a receipt, explanation or old form that would clear up the problem in
question.
All you have to do is supply the document to the IRS via mail and then it
will all be over. This kind of tax form inspection is called the
correspondence audit and is the least intrusive of three types of audits the
IRS conducts.
Unfortunately, sometimes receiving a letter from the IRS is out of your
control. As mentioned before, one of the potential red flags is a
high-income increase from the previous year. It very well may be that you
recently got a great job or promotion that saw a huge hike in your salary.
The IRS may be suspicious of your income and ask for more proof, even if
you made a note of this on your tax return. Respond swiftly to the
correspondence audit to quell any reservations.
2- Office audit
The second type is called an office examination. This occurs when the
problem is serious enough to necessitate a meeting between you and an
IRS worker at a local branch of the agency.
When at these meetings, bring only the documents required and be
honest. Do not flood the IRS agent with extra forms, unless you want
further problems. This may seem like a real pain, but it could be worse...
3- Field audit
That's right; you could be receiving a field examination, the third type of
audit. Here, an agent visits your business or home and does a thorough
inspection of your lifestyle. He will check out where and how you live,
what physical assets you have, as well as anything else that may provide
information as to why you reported your income the way you did.
Usually reserved for the wealthy, these audits are intrusive and
nerve-racking, to say the least.
If you follow these basic, sometimes challenging, tax filing tips, chances
are that no red flags will come up when your report is processed. This
decreases the chance of an audit and may even change your opinion of
the IRS.
