The IRS has made no secret of the fact that it is ramping up audits in order to close the "tax gap." The "tax gap" is the difference between what the IRS expects to collect and what it actually does collect. In 2005, the IRS estimated this gross tax gap, before collections efforts, to be approximately $345 billion.
The good news is that the IRS doesn't expect to shrink the tax gap with random audits. While it's true that some returns are randomly selected for examination, most of the time the IRS has a reason for plucking a form 1040 out of the pile. In other words, audits are generally triggered by a specific item or pattern of behavior on your tax return (or tax returns). Following is a brief checklist of items or behaviors that might trigger an audit:
1. Failing to Include a Form 1099 or Other Income
The IRS suggests that over 60% of underreported individual income tax is related to business and self-employment income, so ensuring compliance with those individuals is a priority. As part of their efforts, the IRS matches forms 1099 in their records to the amounts on your return, so make sure those are correct.
2. Inflating Home Office Deductions
If you use part of your home for business, you're entitled to deduct the related costs as a home office deduction. However, to qualify for the home office deduction, the IRS says you must use the part of your home attributable to business "exclusively and regularly for your trade or business." That means your home office must be your actual office, not just a spot in your home where you sometimes do work, and it must be exclusively workspace and not used for other purposes. In most cases, you'll calculate your deductions based on the size of your home office -- measure carefully and resist the temptation to overstate the size of your office.
3. Citing Too Many Losses on a Schedule C
Filing a Schedule C isn't generally enough to trigger an audit, but taxpayers who file a Schedule C may be statistically more likely to face an audit. One reason is that there is a temptation to overstate losses on your return. Keep in mind that the IRS assumes you're in business to make money. Filing a loss year after year might make the IRS question whether you're serious about your business -- and how you're getting by.
4. Claiming Disproportionately High Charitable Deductions
Charitable deductions are one of the most common deductions claimed on a personal income tax return. In fact, more than 90% of taxpayers who opt to itemize claim charitable deductions. Taxpayers who claim the charitable deduction donate, on average, about 3% of their income. Of course, many taxpayers routinely make large donations due to religious or other charitable reasons. If you're one of them, be sure and document your donations properly, especially cash donations, and make sure the values of non-cash donations make sense.
5. Using Too Many Round Numbers
You know how every now and again, your bill at a store will turn out to be $20 even, and you find that hard to believe? The IRS looks at tax returns that way, too. Your tax return isn't intended to be an estimate. You should report your actual items of income and losses, not approximations. If the IRS sees too many numbers that look like guesses, they may ask you for supporting documentation.
6. Reporting Rental Real Estate Losses When you Don't Materially Participate
As a rule, the IRS considers all rental real estate activities that aren't performed by real estate professionals to be passive activities. For tax purposes, that means expenses associated with rental real estate activities will be deductible only to the extent of rental income (some exceptions apply). However, if you're considered to be in the business of renting real property because of your active involvement, you may be entitled to deduct rental real estate losses in full.
7. Citing Too Many Business-Related Deductions
To be considered a bona fide business expense, an expense must be both "ordinary and necessary ... in carrying on any trade or business." If you have a lot of deductions that seem a bit out of the ordinary for your trade or business, you may call attention to your return. A good rule of thumb when determining whether to claim a business-related deduction is that there should be a clear connection between your expenses and your business in order to take the deduction. Don't try to make something fit that clearly doesn't qualify, and, of course, keep excellent records.
Remember that there's nothing in the tax law that says you should pay more in taxes than you have to ... so don't be afraid to take legitimate deductions on your return. Be careful, however, to report income and expenses properly and keep good records.
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