A+BxC=Audit

Most everyone knows that there are certain common parameters that make you more likely to get audited by the IRS, such as:

  • making more than $100,000
  • having low income and high expenses
  • carrying inventory
  • claiming high deductions for meals and entertainment, travel, and car expenses
  • being self-employed and/or claiming a home office
  • holding a mostly cash-income job, such as waiting tables or bartending

But did you know that the IRS actually uses a very strict formula to determine most of the tax returns that get scrutinized? It’s called the “DIF Score,” (Discriminate Income Function) and while the actual formula is very closely guarded secret, it generally works by comparing your income and deductions to other people in your tax bracket. If you donate an unusual amount to charity, or claim an unusual amount of driving mileage compared to others who make about the same as you, your DIF score goes up. The highest scoring returns then get scrutinized by an IRS agent, who determines whether your return warrants an audit. There are other factors that go into your DIF score as well, such as your age and where you live. If you’re 45, live in Beverly Hills, and claim a $25,000 income, for example, your score goes up simply for having unrealistic numbers.

So how can you stay under the radar? There are several strategies, but here are some of the most common:

  • File a neat, professional-looking return. Messy, handwritten returns require closer scrutiny to begin with, and are more likely to include things like mathematical errors.
  • File at the last possible minute. Prepare your return early and have it checked, but don’t turn it in until as close to April 15th as possible. You may even be able to file as late as the October 15th extension date (though you will still need to pay by April 15th). The later you file, the more likely it is that the IRS will have already reached their audit quota.
  • Check and re-check your return. Mathematical errors, wrong social security numbers, lack of signatures, disagreements between your state and federal returns, and numbers that don’t match your W-2 or 1099 forms (of which the IRS gets their own copies) will all red-flag you.
  • Preempt unusual deductions (e.g. your car got totaled or your office burned down) by including a note and receipt about the incident with your return.
  • Watch your medical expenses. You can only claim non-reimbursable expenses (whether you were actually reimbursed for them or not) in excess of 7.5% of your adjusted gross income. This is a complicated deduction, and one that people very often claim incorrectly, so the IRS really likes to pounce on this one.
  • Don’t round numbers up or down.
  • Avoid the use of “miscellaneous” or “other” categories as much as possible.

In the end, even if you manage to blend in with the masses, your return may still be flagged for a random audit. It is therefore best to keep neat receipts and records for everything you claim (see future posts for how to keep proper expense diaries). The more organized you are, the quicker and less painful an audit will be.

Sources: http://money.cnn.com/2004/02/27/pf/taxes/avoidanaudit/index.htm
 http://www.totaltaxsolutions.com/avoid-audit.htm
http://www.askmen.com/money/investing/40_investing.html
http://articles.moneycentral.msn.com/Taxes/AvoidAnAudit/5waysToAvoidAnAudit.aspx

Tax Tip #2: Home is Where the Profit is

If you’re like me and you have the smallest of small businesses (i.e. the home office), you’re probably hoping to take a nice, juicy deduction for the portion of your rent and utilities that goes towards supporting your home office. Do you want the good news or the bad news first?

Alright, first the bad news: if the income you made working for yourself is less than your total expenses for the year, including the home office portion of your rent and utilities, you cannot take this deduction. In other words, the IRS will not let you deduct the office portion of your home if it operates at a loss. In my case, because I was teaching for most of 2007, I was an employee during those months and not working for myself. Nevertheless, I was also starting a business, so my expenses for the year were about $2,000 more than the income I made working for myself rather than for the school.

Okay, now the good news: the home office deduction rolls over from year to year until your self-employment income exceeds your expenses. That means that in 2008, assuming my business makes a tidy profit, I can deduct the rent and utilities for my home office from 2008 and 2007!

In short, if you have a home office that eventually makes some money you will get your deduction, just maybe not right away. Be careful about the size of the refund you are expecting this year, especially if you started your business in 2007 or finally took it full-time.