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The Ins and Outs of Audits
According to the Kiplinger Letter, random federal tax
audits are starting up again in October after a brief hiatus —
about 13,000 taxpayers will receive letters. These are the
infamous "line" audits, designed to provide a database
to be used in designing guidelines for more efficient inspection
of returns. Agents will reportedly be looking specifically for
hidden or underreported income and exaggerated credits and
deductions listed on Schedules C (profit or loss from business)
and F (profit or loss from farming).
The government has been focusing for awhile on the increasing
number of self-employed individuals. Even if you dodge the
bullet for now, it's always smart to be vigilant against the
expensive and stressful possibility of a tax audit. A qualified
tax professional can assist you in the preparation of your
return to minimize the chances of an audit coming your way.
There are three types of audits:
- Correspondence audits
happen when the IRS sends a letter asking for clarification
on relatively simple items. It's usually handled and
completed through the mail.
- Office audits are
conducted on the IRS's turf. You meet with an examiner who
wants to see documentation intended to answer their specific
questions. It's wise not to volunteer any other information
beyond what they ask.
- Field audits are the
stuff of TV cop shows. That's when the IRS comes to your
home and starts nosing around to see why that Bentley is
sitting in the driveway of someone who reported $28,000 in
income last year. These tend to be pretty serious.
There are some obvious no-no's that shift your return to the
audit pile. The following measures won't guarantee you'll avoid
an audit, but they're key issues that the IRS focuses on when
deciding which returns to target:
Messing up the basics: This is an obvious point, but
remember to sign the return, add the Social Security Number and
double-check the math. Fill out every applicable line on the
return, or better yet, get a tax preparer to do it since
professionally prepared returns tend to be easier to read and
understand because you're paying qualified people to get it
right. Bottom line — sloppy returns tend to draw scrutiny.
Rounding can be a problem: Precise numbers suggest
precision. It's always best to show conservatism to the IRS.
Round down to cut off the pennies, but rounding up to the next
hundred or thousand tends to draw attention.
Note sales of investments carefully: Anytime you sell
stocks or bonds, the IRS and the taxpayer receives a 1099 noting
the sale price. Your tax professional can go over the proper way
these should be noted on your return. Also remember that income
items such as interest, dividends and other sources of income
are matched with the return from documents that are already on
file with the IRS.
Scores are everywhere: In case you didn't know, the
IRS — like the lending industry — assigns you a score. It's
called the Discriminate Information Function (DIF), a computer
program that compares, among other things, the deductions you're
taking against others in your income bracket. It's the way an
increasingly technology-driven IRS is screening for suspicious
returns. One of the best ways to avoid a high DIF score is to
report all income — don't let yourself think that any amount is
not worth reporting.
Be wise about itemized deductions: You should claim
every deduction the law entitles you to, but a good tax
professional can advise you of reasonable limits that are less
likely to trip your return. In particular, the IRS looks for
overblown charitable deductions — make sure you make cash
contributions by check or credit card so there's a record, and
just make sure that all your donations have receipts or other
acknowledgement from the charity — that's a strict requirement
of the Pension Protection Act of 2006. If you do get audited,
you need to prove the original value of the items donated and
their fair market value.
Keep scrupulous mileage records: If you use your
vehicle for work or business, keep a notebook or chart in the
car so you can record mileage information as soon as you
complete it. The records should list beginning and ending
odometer figures, location and reason for the trip. Keep the
same records for mileage claimed for medical expense and
charitable purposes.
Watch that home office: Even though the government
loosened restrictions on home office deductions in 1999, make
sure you can substantiate that business area of your home if
you're asked.
September 2007 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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