My husband and I are currently hard at work on our 2016 tax return, which includes both our business and personal information. Do you have any advice for us? We’re hoping to minimize our chances of undergoing an audit.
No one wants to pay more tax than necessary, but the risk of an IRS audit keeps many business owners and individuals from taking full advantage of tax deductions and credits that can help them. Audits are rare, and most of us will avoid them altogether. And remember, even if you are selected for an audit, it doesn’t necessarily mean anything is wrong. Returns are always subject to random sampling so there’s really no way to guarantee you will avoid an audit. However, you can reduce your odds.
Arithmetic errors and missing information are common mistakes but are usually addressed by correspondence. Most audits are triggered by the type and amount of the deductions taken. The IRS uses sample tax returns as guidelines to compare your deductions to others in your income bracket and weighs the differences. Therefore, if something deviates substantially, it may trigger an audit. Ultimately, the best way to prepare for an audit is to do a great job of record keeping throughout the year.
Most IRS tax audits come in the form of letters asking for explanations or supporting documentation of certain items on your return. So if you receive a tax audit letter, don’t ignore it. Contact the advisor who prepared your tax return because they can explain the IRS tax audit process and help you prepare by determining the nature of the audit and reviewing your records. The IRS may want to audit the entire tax return or audit just a portion of your return, such as business meals and entertainment or automobile and travel expenses. It is critical that you have documentation supporting the expenses.
Here are some red flags that may increase your chances of unwanted attention from the IRS:
Are you making too much money? Making money is a good thing and most people strive to make as much as possible. However, be aware that IRS statistics show that people with incomes exceeding $200,000 are more likely to be audited than those with lower incomes. If you are fortunate enough to be in this category, make sure your records and supporting documents are in good order.
Remember to report all your income. Take the time to collect all the forms sent to you by employers, banks and other organizations so you don’t overlook any income that should be included on your return. The IRS gets copies of all 1099s and W-2s you receive, so make sure you report all required amounts. Excluding income is one of the most common reasons for the IRS to select your return for audit.
Rental property losses. Do you show income from your job or business and claim rental property losses? If you do, be very wary. The IRS rules limit deducting those losses in the current year for most taxpayers.
Don’t forget foreign bank accounts. Failure to report a foreign bank account or investments can lead to severe penalties, and the IRS has made this issue a top priority. Therefore, if you have any such accounts properly report them when you file your return.
Dependents and exemptions. Any dependents you claim must meet the legal definition of a dependent. Make sure you claim the correct number of dependents and exemptions and include the relevant social security numbers.
Large donations. If your charitable deductions are disproportionately large compared with your income, it will raise a red flag. As we mentioned above, IRS computers compare the average charitable donation for your income level, so be cautious and don’t exaggerate the value of non-cash donations. Make sure you have receipts and/or the proper documentation to support your contribution deductions. Also be aware that if you take a deduction for a large contribution (such as property or a conservation easement), additional requirements will be necessary, including an appraisal.
Live within your means. Does your tax return accurately reflect your economic reality? The IRS may raise an eyebrow if you report $70,000 in charitable donations on a $150,000 salary. Review the reasonableness and accuracy of your deductions.
Remember to check (and double check) your return. The fewer reasons the IRS has to review your return, the better. If you do get an audit notice from the IRS, don’t panic, but consider engaging an experienced CPA or attorney to represent you in the process.
Tom Cooney and Crystal Faulkner are partners with MCM CPAs & Advisors, a CPA and advisory firm offering expert guidance and beyond the bottom line thinking for today’s public and private businesses large and small, not-for-profits, governmental entities and individuals. For additional information, call 513-768-6796 or visit us online at www.mcmcpa.com.