Avoiding An Audit
GETTING AUDITED by the Internal Revenue Service really isn't the end of the world, as columnist Dave Barry once calmly observed. "All that happens is, you take your financial records to the IRS office and they put you into a tank filled with giant, stinging leeches. Many taxpayers are pleasantly surprised to find that they die within hours."
Talk to a few people who've really been through the process and you'll realize Barry wasn't exaggerating all that much. If it wants to, the IRS can seriously mess up your life, in ways that often seem arbitrary and bizarre.
The chance that you'll actually suffer an audit this year is quite remote. Fewer than 2% of all the individual income-tax returns filed in each of the past several years were audited, IRS reports show -- 1.28% for the most recent year statistics are available. Still, the odds of being audited do rise sharply for people who fit certain profiles.
A lot of it depends on the secret IRS computer program that scans every return and then assigns it a score indicating the likelihood of questionable items. Despite the IRS's penchant for secrecy, some entries the computer searches for are fairly obvious, former IRS officials say. Among these are itemized deductions that represent an unusually large percentage of the taxpayer's income. Naturally, the IRS won't say how it defines "unusually large." But because of the intense interest in this subject, the Research Institute of America, a tax-information publishing company, calculates averages each year for major categories of deductions, based on adjusted gross income.
| WHAT'S ON AN "AVERAGE" RETURN | ||||
| Yearly Income (in thousands) | Taxes Paid | Charitable
Contri- butions | Deductible Interest | Percentage of Filers Itemizing |
| 3050 | 3,056 | 1,536 | 5,873 | 40 |
| 50-100 | 5,001 | 2,025 | 7,220 | 73 |
| 100-200 | 9,544 | 3,367 | 11,023 | 92 |
| 200+ | 35,386 | 17,993 | 22,258 | 93 |
| Source: Treasury Dept. Statistics of Income Bulletin, Spring 1998 | ||||
The table above shows the latest numbers, based on returns filed during 1997 for 1996. A word of caution: Remember that these are only averages, and not what the IRS officially considers acceptable. Even with that caveat, though, this table can be useful. If, for example, you find that some of the items you are claiming are particularly outsized for your category, consider attaching an explanation or copies of documents to support them. That could help calm suspicions.
Other ways of singling out returns are less sophisticated, such as the agency's "related examinations." These are what you get for, say, doing business with someone whose return is audited. There are also "chance" audits, triggered largely by, well, chance. Perhaps an agent saw something about you in your local newspaper or on television that piqued his curiosity. Or a disgruntled ex-spouse or former business partner turned you in to the IRS, hoping to collect a reward.
| WHOSE RETURNS GET EXAMINED | ||||
| Forms 1040, 1040A, 1040EZ* | % Audited in Fiscal 1997** | |||
| Income of $25,000 to less than $50,000 | 0.70 | |||
| $50,000 to less than $100,000 | 0.77 | |||
| $100,000 and over | 2.27 | |||
| Schedule C (Sole Proprietorships) | % Audited in Fiscal 1997 | |||
| With gross receipts under $25,000 | 3.19 | |||
| $25,000 to under $100,000 | 2.57 | |||
| $100,000 and over | 4.13 | |||
| Estate-Tax Returns | % Audited in Fiscal 1997 | |||
| Gross estates of less than $1 million | 6.83 | |||
| $1 million to less than $5 million | 18.88 | |||
| $5 million and over | 47.43 | |||
| *Total
personal income before deductions, losses and other
adjustments **Calendar 1996 returns Source: Internal Revenue Service, 1997 Data Book | ||||
Here are some of the other items that tend to raise examiners' eyebrows:
- Filing Schedule C. If
you own your own business, deal in large amounts of cash and file
Schedule C, your chances of being audited rise sharply. As you
can see in the table above, in 1997 more than 4% of returns with
a Schedule C showing income of $100,000 or more were
audited.
- Taking a home-office
deduction. The rules here are so complex and limiting that IRS
agents figure they have a good chance of squeezing more revenue
out of many taxpayers who claim a home office. The tax law
enacted in 1997 will allow more consultants and other
self-employed workers to qualify for the deduction, but not until
1999. And it won't remove many other ambiguities and limitations.
So don't expect the IRS to ease up on its scrutiny.
- Writing off large
amounts of travel and entertainment expenses. A classic example
would be a businessman who deducts the cost of his daughter's
wedding on the grounds that all the guests were customers. Yes,
that really happened, says Cornelius J. Coleman, a former IRS
official and now director of national tax services at Coopers
& Lybrand in New York.
- Racking up large
losses in a business each year for many years. That could prompt
the IRS to conclude that there is no evidence you are in business
to earn any money. An example would be people who say they are in
the business of breeding horses or collecting antique cars, but
have never once shown a profit.
- Taking large casualty-loss deductions. Very few people qualify for such deductions. Thus, says a former IRS official, those filers who take them tend to stand out and get asked questions, even if they are innocent.
- Being careless or
lying. One easy way to get asked tough questions is to not report
income you received that was reported to the IRS by whoever paid
you. That's why it is so important to make sure whatever you
write down matches exactly whatever is on an "information return"
such as the W-2 form you receive from your employer.
- Living better than you
seem able to afford. Even the IRS's ancient computers are smart
enough to figure out that a Beverly Hills address is tough to
maintain on Burger King wages. Sure, you may have an excellent
explanation. You'd just better be prepared to share it with the
IRS.
- Filing an estate-tax
return. These returns draw unusually heavy scrutiny, reflecting
the large amounts of money typically involved. The agency audited
about 13% of all estate-tax returns received for 1996. That
percentage rose to a startling 47% of all returns showing a gross
estate of $5 million or more.
- Being in the wrong
place at the wrong time. Unfortunately, where you live plays an
important role in your chances of losing the audit lottery. Audit
decisions aren't made by computers in Washington; they are made
by local IRS officials, based on their own staffing levels and
resources. According to IRS statistics, the Los Angeles region
was the most active of all -- 1.55% of all returns were examined.
Ohio's rates were lowest; residents there were audited only 0.31%
of the time.
If that doesn't make you want to move to Ohio, we don't know what will.
This publication is for general informational purposes only and it is not intended to provide any reader with specific authority, advice or recommendations. Where you deem necessary, we suggest that you seek advice regarding your particular situation from the appropriate professional.
