What Are Your Chances of Being Audited by the IRS?

General Information

Only a small percentage of all the individual tax returns filed each year will be audited. The selection process is done largely by computer models. These were designed by looking at millions of tax returns and developing "norms."

If your tax return has numbers that fall very much outside these norms, your chances of being audited increase.

Individual returns are divided into groups based on the type of work you do and the level of income you report. For example: The IRS expects to see a certain amount of itemized deductions on tax returns reporting between $50,000 and $100,000 of income. Doctors with a certain specialty in a given geographic area are expected to report a certain amount of gross income. The groupings, breakdowns, and average dollar amounts are a closely guarded secret by the IRS.

Business returns are grouped by the type of business and their geographic location.

If your income is unusually low or your deductions are unusually high for a given year, you should attach an explanation to your tax return. After the computer selects a return for possible audit, a human being examines the return to see if the computer made a proper selection. Your attached documents may keep you from getting contacted by the IRS.

Congress is alarmed by the latest IRS estimate that about $450 billion is lost to those who cheat on their tax returns.

Three Main Types of IRS Audits

There are three main types of audits done by the Internal Revenue Service.

1. The simplest is the correspondence audit. You will get a letter from the IRS requesting that additional information be mailed to them or that a proposed additional amount of tax be sent in.
2. The second level of audit is the office audit. You will be asked to bring certain information to the IRS office for review.
3. The most complete audits are called field audits. They are conducted at your place of business. It is best to avoid these if possible. Once the agent is at your place, he or she has much more to see and ask about.

Red Flags

The Internal Revenue Service is interested in auditing returns that are most likely to produce additional revenue. Here is a list of some of the items which draw attention to your tax return:

• Participation in tax shelters, including offshore trusts.
• Use of offshore credit cards.
• Your occupation if you are in a business which is often paid in cash, such as taxicab driver, hairdresser, or waitress.
• Businesses run by a single family, especially those reporting on Schedule C, since they often make all the decisions and do their own recordkeeping.
• Returns claiming a home office deduction.
• Big deductions for business travel and entertainment expenses.
• Sloppy tax return preparation.
• Returns that are filed without the necessary supporting tax return schedules.
• Business losses several years in a row.
• Low S corporation shareholder salaries in relation to other distributions.
• A major change in your income compared to your prior tax returns.
• Deductions for automobile expenses.
• Noncash charitable contribution deductions.
• High mortgage interest deduction and low income.
• High damage or theft loss deductions.
• Early withdrawal from an IRA account which is not rolled into a new account or reported on your tax return.
• Deductions for "independent contractors" (versus employees) on business returns.
• Conviction of a money crime where stolen property or stolen money is taxable.

This is only a partial list. There are different red flags for different industries, professions, and income levels. The IRS is constantly changing what it uses as audit indicators.

Document Matching

If you fail to report income on your tax return which was reported to the IRS on a document (such as an interest statement from your bank), the audit adjustment is all but automatic. If you receive interest, brokerage statements, or other information returns with the wrong amounts, try to get a corrected copy. If you can't get a corrected copy, include your explanation with your return as to why you are reporting a different number on your return.

What To Do If You Receive an Audit Notice

If you receive a notice from the IRS, don't ignore it. You can rest assured that the IRS will not just go away. All contacts by the IRS should be handled promptly. Unless you are an accomplished IRS "fighter," you would be wise to seek professional assistance from the very first correspondence.

Getting "chatty" with an IRS agent or providing information or documents which you were not asked to provide is ill-advised. Such excess information may expand the audit into areas which were not of initial interest to the agent. Your attempts at being friendly with the agent may end up costing you more time and money than is necessary.

On the other hand, the only taxpayers who need to fear the IRS agent are those who have cheated on their tax return or who can't provide the documents necessary to support the numbers on their return.

In a Nutshell

If your tax return looks unusual when compared to your prior-year tax returns or when compared to industry or occupational norms, there is a good chance that you will hear from the IRS. Your best defense against a potential audit is a properly prepared and properly documented tax return. If you haven't used a professional tax preparer before, now may be the time to engage one.