An IRS audit is an in-depth examination of your financial information to ensure that the information you provided to the IRS is accurate and has been reported correctly. Specifically, when you are being audited by the IRS, they will request supporting documents to prove that the numbers you have provided on your tax returns are accurate. They often perform audits because they believe some information may have been stated incorrectly, whether it was because of a mistake or a deliberate omission or misstatement.
IRS audits are never fun, even if you did everything you should have done. Finding supporting documents for income, deductions, and credits can be very time-consuming and annoying. While some audits are random, the IRS targets individuals or entities with some common attributes. In some situations, you may be able to take action to decrease the chances of being audited by the IRS.
What Can Trigger an Audit?
A few factors will often throw up red flags that might trigger an audit. The following circumstances can cause additional review or audit by the IRS.
Discrimination Information Function (DIF)
The IRS examines tax returns using a computer software referred to as the “Discrimination Information Function” (DIF). This program “scores” each tax return on the basis of various factors, and if a tax return scores high enough, it will flag the return for a potential audit. The score is mostly based on how much a tax return changes from one year to the next. It uses information based on IRS experience with similar returns to determine how much a particular return may change from year to year.
If a tax return scores high on the DIF, then IRS personnel will personally review the return to determine whether an audit is appropriate.
Earning Higher Incomes
The higher your income, the higher your chances are of being audited. Even at the highest rates, the chances of being audited are only 8.16%, but that rate only applies to those earning over $10 million. If you earn between $1 million and $10 million, the rate drops to 2.53%. If you earn less than $1 million, the rate is below 1%. However, those who make over $500,000 per year have a higher chance of being audited compared to someone who earns income closer to the median range.
Failing to Report a Foreign Bank Account
If you have cash saved in another country or received income from another country, you have an increased likelihood of being audited. The potential of raising a red flag increases if the transactions are over $10,000 as well.
Blurring the Lines on Business Expenses
The IRS will likely review your return with extra scrutiny if your business expenses are much larger than other businesses like yours. Mixing personal and business expenses is another area the IRS doesn’t want to see. Be aware of what you are deducting for meals, travel and entertainment and make sure you have clear records that document the business reason for each expense.
Large Cash Deposits
Interestingly, if you deposit or spend more than $10,000 in one sitting, the IRS may be watching that type of activity. Those kinds of transfers can signify that you are not properly reporting income or other problems. As a result, large cash deposits could lead to an IRS audit.
How Far Back Can the IRS Audit You?
As a rule, the IRS can review your returns for the past three years in an audit. However, if there is a substantial error, then the IRS may want to go back even further. In general, the IRS will not attempt to audit any return that is older than six years old. Most audits actually occur within two years of the date that your return is filed.
Real Tips to Decrease the Chances of an IRS Audit
1. File Taxes on Time
When you file your taxes on time, you file at the same time as millions of other people across the United States. The IRS personnel simply have less time to review returns when everyone files at the same time. However, if you file late, the IRS may have more time to take a closer look at your return. When the IRS has more time to review, they might also have more time to audit.
2. Avoid Rounding Numbers
When your deductions, credits, business expenses, or other items have rounded numbers, that is an indicator that you are actually just guessing about the amount involved. Guessing about amounts also leads the IRS to think that you are “making up numbers,” even if the guesses you are using on based on fact. Instead, use the real income, costs, etc., for each item. It is far less likely that you will have numbers that end in zeros and fives when you do that.
3. Do Not Omit Any Information
Everything on your tax return should match the paperwork that you have. While everyone forgets information from time to time, you should always do your best to include everything you can in your return. If you realize you have forgotten something, you may need to take the time to amend the return to include it. However, amending the return can raise red flags, too, so it is best to include everything you have the first time you file.
4. Do not Leave Questions Blank of Tax Forms
Avoid having no response at all to questions on the tax forms. If you do not know the information, you should find it. If the section does not apply to you, use “N/A” or something similar to fill in the blanks.
5. Avoid Amending Returns
Amending your return can draw unnecessary attention to your tax filings. If you amend your return, especially if it adds more deductions or credits, that can cause IRS personnel to take a second look at your return. That second look can result in a formal audit in many situations.
The IRS only audits a very small percentage of all tax returns. Nonetheless, going through an audit can be both nerve-wracking and time-consuming, so taking steps to avoid an audit will likely be in your best interests. Simple things like filing on time and being as accurate as possible will help decrease the chances of being audited.
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