The thought of receiving an audit letter from the IRS probably sends shivers down your spine. But by avoiding foolish mistakes and taking the right steps now, you can minimize your risk of an IRS audit down the road. Click through to find out how you can prevent a tax audit and avoid common mistakes.
1. Enter Your Identifying Information Correctly
Although it sounds obvious, make sure you do the simple things correctly. Making a mistake while entering your Social Security number or misspelling your name can result in the IRS rejecting your return. If this happens, you will have to refile, which will delay how quickly you receive a refund.
2. Enter Your Numbers Accurately
The income amounts you enter on your return must match the information the IRS receives through W-2 and 1099 forms sent by your employer or others who paid you during the year.
"The IRS computers cross-check the information reported to them on your tax return with the information that is received from businesses filing informational returns," said Crystal Stranger, a Los Angeles-based enrolled agent, National Tax Practice Institute fellow and president of 1st Tax, a tax firm. "If this information is not a match, you are nearly guaranteed to receive a computer-generated audit letter."
3. Report All Income
If you make any money outside your regular job, you need to report the earnings on your tax return, said David M. Hryck, a partner with the law firm ReedSmith who practices in New York. "If the person (or) company that is paying you reports the business, you would definitely be raising a red flag," he said.
For example, if you do freelance photography for a company that reports your payment as a business expense, the IRS expects to see the same amount listed as income on your return.
4. Avoid Claiming ‘Abnormal’ Amounts of Income or Deductions
The IRS selects some returns for audit based on how different your return is from the statistical norms for your area, business type, household size and other factors, said Jeff Balsz, a Glendora, Calif.-based attorney with a master of laws in taxation and owner of Solo Tax Software.
If you are entitled to the deduction, you should claim it. But be prepared to back it up if the IRS inquires.
5. Minimize Year-to-Year Differences
The IRS also identifies returns it intends to audit based on comparisons with your tax returns from previous years. "If there is a large differential of an amount from one year to another, it would increase your chances of being examined," said Craig Smalley, an enrolled agent and founder and CEO of CWSEAPA, an accounting and financial services firm with offices in Delaware, Florida and Nevada.
For example, your risk of an IRS audit might rise if you claim $2,000 of mortgage interest in one year, and $25,000 of mortgage interest the next year.
6. Report All Foreign Income
You must report all income on your U.S. tax return, regardless of where you earned it.
"People need to understand that just because they're saving or earning money outside of the U.S., it does not mean the money is free money," Hryck said. Fail to declare this cash, and not only are you at risk of an audit, but you might also be guilty of a crime if you are hiding offshore income.
7. Avoid Claiming Excessive Mileage Deductions
The IRS will compare the amount of business miles you claim as a deduction to what is standard in your occupation, said Dave Du Val, chief customer advocacy officer at TaxAudit.com.
"We see a lot of returns that report thousands of miles driven for business, but they have an occupation listed that doesn't typically require travel," he said. "And when you think it through, their reporting would have them driving all day every day of the year — which of course doesn't make sense."
8. Only Claim the American Opportunity Credit If You Qualify
The American Opportunity Tax Credit offers money back on your taxes for higher education costs. You can claim it for up to four years of higher education as long as you're seeking a degree or other recognized credential, enrolled at least half-time and meet other requirements. However, this is a credit that's receiving additional IRS scrutiny, Smalley said. So don't claim it unless you're entitled to it.
9. Don’t Falsely Claim Dependents
Each dependent you claim lowers your taxable income. But you cannot claim dependents on your return if they are being claimed on another return.
"One of the more simple mistakes includes claiming an exemption for a dependent on a parent's tax return, where the same exemption is unwittingly claimed on the dependent's separate tax filing, or where the same exemption for a dependent is claimed by both married persons filing separately," said Nate Smith, a director in the National Tax Office of CBIZ MHM in Atlanta.
10. Be Conservative With Deductions If You Earn a High Income
Simply making more money during the year increases your IRS audit risk, said Smith. "Tax returns that report more than $200,000 of income are audited more frequently than those below that threshold," he said. He added that tax audit activity is even higher for returns reporting income in excess of $1 million.
11. Report Your Foreign Accounts
Having a foreign account is not illegal. For example, you might work or live abroad, or have other legitimate reasons to have an overseas account. However, you must file Form 8939 if your foreign financial assets exceed the thresholds for your filing status.
For 2016 returns, single U.S. residents must file Form 8939 if their foreign assets exceed $75,000 at any time during the year, or $50,000 as of the end of the year. If you file jointly, those thresholds are doubled. Correctly reporting all of your accounts reduces your odds of IRS scrutiny.
12. Obtain the Required Minimum Health Insurance
The Affordable Care Act requires most people to purchase a minimum amount of health insurance coverage. "Not having health insurance will trigger a penalty, and not paying that penalty can trigger a possible audit," said Hryck. Although there are no criminal penalties, the IRS can withhold future tax refunds to cover the penalty.
13. Avoid Early Retirement Withdrawals
Taking money out early from a retirement plan such as a 401k or IRA can trigger heightened scrutiny of your return, according to Hryck. "Typically, the IRS is under the assumption that people who are withdrawing early tend to make mistakes on their tax returns," he said.
14. Don’t Claim the Earned Income Tax Credit Unless You Qualify
The Earned Income Tax Credit offers a refund to people who have earned income below certain limits, and who typically have at least one qualifying child and meet other requirements.
The EITC is "a big thing this year," Smalley said. "The IRS has said that all refunds will be delayed because they will be verifying numbers." Of course, if you're entitled to the credit, you should claim it.
15. Don’t Claim Political Contributions as Charitable Contributions
Although you might think you're improving society by making contributions to your favorite politician, you aren't allowed to include those amounts as part of your charitable contributions deduction.
"The IRS is more than likely to review returns claiming large charitable contributions, as political donations are not tax deductible," said James Oliveri, owner of NYCTaxguys in New York and a registered tax return preparer.
16. Keep Your Business and Personal Accounts Separate
If you own a business, don't use the company accounts as your personal piggy bank. "Be careful how you categorize monies being put into your business, and monies being taken from your business," said Oliveri. "The IRS could come back and classify some of the money taken as a taxable event."
17. Choose a Reputable Tax Preparer
The IRS has instituted an oversight program to flag returns prepared by tax preparers who have been criminally charged for tax fraud, said Balsz. If your tax preparer is on the IRS list, it might mean trouble for you.
"If your return preparer has been flagged by your local audit office, or collections, or by the IRS' own database itself, then your return can be flagged for an audit, regardless of any items on the return or your own actions," Balsz said.
18. Don’t Claim the Additional Child Tax Credit If You Don’t Qualify
If you have a qualifying child, you can reduce your taxes by claiming the Additional Child Tax Credit. This credit is for people who get less than the full amount of the Child Tax Credit. Qualifying children include your kids, foster children and even siblings. However, they must be under 17 at the end of the year and can't provide more than half of their own financial support.
The Additional Child Tax Credit is another credit the IRS watches closely, said Balsz. If you know you're eligible, don't let that deter you from claiming the credit. Just make sure all of your information is entered correctly.
19. Report All Investment Income
Your income doesn't just include wages, but also gains from stocks, bonds and interest. If you're in a rush to get a refund, it's possible to accidentally forget about such income. "I had a client who had stock sales of $50,000," said Oliveri. "She never reported it on her return and, lo and behold, the IRS wants $10,000 in taxes."
20. Reconcile Health Insurance Premium Tax Credit Advances
If you got an advance payment of your health insurance premium tax credit, you must do extra work to make sure you were eligible to receive it. "Taxpayers receiving such advance payments must reconcile them on Form 8962 to determine ultimate eligibility for the credits, which are reported to the taxpayer on Form 1095-A.2," said Smith.
21. Don’t Claim to Be a Real Estate Agent Just to Get a Tax Break
If you have rental properties that generate a tax loss, you usually cannot use the loss to offset other income because the IRS classifies the event as a "passive activity loss." Instead, you must carry the loss forward until you get rid of the property or have taxable gains.
However, if you materially participate in the real estate management — such as if you are a real estate professional — you can take the loss that year. Some people falsely claim to be "real estate agents" so they can claim such a loss. Typically, "material participation" requires working in the business for more than 500 hours. Du Val said the IRS looks closely at taxpayers who claim "real estate professional" status to avoid the passive activity loss limitation.
22. Consult With a Qualified Tax Preparer
The tax code can be difficult to read and understand. So, it's often wise to consult with a tax professional. If you're not sure if you qualify for a deduction, the money you save by avoiding an audit can more than cover your costs. And don't try to take shortcuts by finding a cheap tax preparer just so you can save money. Some return preparers are actually scammers who will steal your refund or identity, the IRS has said.
23. Don’t Make Frivolous Tax Arguments
You've probably heard of people who claim they are exempt from paying taxes because they are a sovereign citizen. Other people say paying taxes is really just "optional." However, the IRS and the U.S. Tax Court have found these and other similarly outlandish arguments to be frivolous. The IRS warns taxpayers that the penalty for filing a fraudulent return is $5,000. In addition, the IRS can audit a fraudulently filed return at any time in the future.
24. Get Receipts for Charitable Cash Contributions
The IRS can disallow a charitable deduction if you don't have proof of the donation. If you gave less than $250, you can use a canceled check, credit card statement or bank statement as proof. If you gave $250 or more, you need a written statement from the charity with information such as:
- How much you gave
- What, if anything, you received in return for your contribution
- The value of what you received
25. Document Charitable Donations of Goods
If you donate goods to a charity, you're eligible to deduct the fair market value if you have the right documentation. If you don't have that documentation, the IRS can disallow your deduction.
If you gave less than $250, you need a receipt that shows the name of the charity, the date and the charity's location, and a reasonably detailed description of what you gave. If you dropped off the goods at an unmanned location — such as putting clothes in a charity's drop box — you can claim the deduction without a receipt.
If you gave more than $250 worth of goods, you always need a receipt.
26. Maintain Records for Employee Expenses
Employee expenses are particularly ripe for IRS inquiries. If you're claiming the deduction, you must have your company's reimbursement policy in writing, said Stranger. To deduct expenses paid for your job, have proof that your company did not reimburse you for the expenses, that its policy is not to reimburse for these types of expenses, and that incurring the expenses was required for you to do your job, she said.
27. Keep a Trip Log for Car-Related Deductions
If you claim car-related deductions — such as business or charity mileage expenses — keep written proof of your business and total mileage for the year, said Stranger. She suggested logging this information in a book, or keeping it in phone or computer apps that create a professional record of auto expenses.
28. Substantiate HSA Distributions With Receipts
A health savings account allows you to put pretax dollars into the account, and then take out the money tax-free as long as you spend the distributions on qualified medical costs. You aren't required to include your receipts for the medical expenses when you file your return, but you must keep them in case you are audited.
29. Substantiate Why Your Costs Qualify
Document why the costs listed on receipts qualify for particular deductions, said Balsz. "If you travel out of town for business, keep a record of the business you performed out of town — for example, the appointment (or) meeting with the client, or the business function (or) seminar you attended." If all you have are plane tickets when the IRS audits your return, you're going to have a hard time proving your deduction was legitimate.
30. Maintain Records Until the IRS Can’t Challenge Anymore
The IRS typically has three years to audit your return. However, there are certain times the tax audit period can be extended. For example, if you underreport your income by more than 25 percent, the IRS has six years to audit you. If you don't file a return, or you file a fraudulent return, the IRS can audit your taxes for that year at any time in the future.