It is a known fact that your individual return being audited is about 1%. But what if you want to lessen it further? As per discussions with CPA’s and EA’s (Enrolled Agents are sometimes former IRS agents in private practice that now represent the public before their old bosses at the IRS) on clients who have undergone audits by the Internal Revenue Service, they have been facing common threads over the years. Therefore, today I have come up with a list of ten triggers that is a must review once in every year to keep you out of trouble. I’ve also included an action with each trigger that will prove to be beneficial if completed. Consult your tax preparer, CPA, or EA in terms of any confusion.
â€¢ Excessive Charitable: It is a deduction done in proportion to your AGI (adjusted gross income). Consider the amount of your total charitable deductions and divide it by your adjusted gross income. If the percentage obtained is above 10% your audit risk is elevated.
Action: Get adequate back-up for charitable deductions especially if your charitable deductions are defined as excessive.
â€¢ Excessive Schedule: It is another deduction done in proportion to your AGI (adjusted gross income). Consider the amount of your total schedule and divide this amount by your adjusted gross income. If this percentage is above 35% your audit risk is elevated and if it is above 44%, a letter from the IRS is on the way.
Action: Get adequate back-up for schedule deductions especially if these deductions are defined as excessive.
â€¢ Filing both Schedule A & Schedule C: While scheduling both A and C file pay attention to each schedule and also on their combined AGI percentage. Make sure that each schedule fall below the danger zone. If in any case the combination is more than 105% of your AGI, watch out for the trouble on the way.
Action: Get adequate back-up for schedule A & C deductions especially if these deductions combined are defined as excessive.
Check out for Action item below for Schedule C filers:
â€¢ S-Corp Payroll: Whenever you file an 1120-S Tax Return and at the same time make a significant amount of income (above $50 K). Say you did not report compensation to shareholders on a W-2; in that case you will be prone to the risk of audit. The IRS looks at this as a way for shareholders to avoid paying self-employment taxes.
Action: Always pay shareholders some amount of compensation.
â€¢ Third Party 1099’s and W-2 statements do not tally with the corresponding tax return. The IRS has employed a matching program uncovering discrepancies. So, if a mismatch is discovered, it will automatically trigger the IRS to send out an inquiry or potentially trigger a full blown audit.
Action: make sure to include all 3rd party statements and strictly do not omit any of these statements from your return.
â€¢ Running your business as a Schedule C filer: Sole Proprietorships are actually the business structures you will have to stick to if by any chance you fail to setup a Corporation, LLC, LLP, etc. The audit rate among unincorporated business with earnings under $25,000 jumps to over 4% – more than four times. Note that all Sole Proprietorships (and single-member LLC’s which the IRS deems are disregarded entities) report their business income and expenses on Schedule C. So, if your Schedule C deductions are less than 52% of your AGI it is not a big deal but if they exceed 65%, it sure is.
Action: Report your business as a Corporation because filing as an S Corporation, you become less likely to be selected for a random IRS audit.
â€¢ Filing your tax return before April 15: Most people believe that by filing during this time-frame their return would get lost in the shuffle of all the other returns being filed at the same time. But rather filing on time may actually increase your chances of being audited. According to our findings, most audit-worthy returns are selected during the summer months from the group that filed on or before April 15.
Action: Ask for the automatic four-month extension and get an additional two months extension which will mean that you can legally file as late as October 15.
â€¢ Stock transactions not corresponding to the third party statements sent to the IRS by brokerage firms: All gross proceeds must reconcile to the 1099 -B transaction statements as reported by your brokerage firm. This new reporting methodology has made reporting short term capital gains extremely difficult for the tax payer. It is considered as a lurking audit flag if tax payers do not reconcile cost basis to what was reported on third party statements.
Action: Make sure that the figures you are reporting on your return match to the underlying third party brokerage statements you have received for both gross proceeds and cost basis (Type A transactions).
â€¢ Mortgage Interest payments not reconciling to third party statements: It is a common phenomenon seen when a homeowner owns multiple houses and/or multiple mortgages on the same property. It is seen in some cases that that taxpayer makes payments but the bank reports to the IRS for another taxpayer.
Action: Make sure that the figures you are reporting on your return match to the underlying third party statements completely and you are entitled to the deduction.
â€¢ Filing Electronically: Filing electronically provides the IRS computer systems with the capability of running mismatch programs to detect irregularities on your return.
Action: Send in a paper return by certified mail with confirmation the IRS received the return.
Always remember that the fear of being audited should not scare you from claiming legitimate deductions as it might push you to the danger zone. Rather make sure that it motivates you to compile and keep documentation necessary to substantiate your deductions. If your return includes any deductions that are unusual in nature or size, attach to your return a written explanation.
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