An unexpected letter from the Internal Revenue Service can make your stomach drop, but you can take steps to reduce your audit risk.
Taxpayers overall face a low audit risk: The IRS audited 1.1% of all individual tax returns filed in 2010, or 1.6 million returns of 141 million filed.
The vast majority of those audits — 1.2 million — was done by mail. Just 392,000 involved an in-person meeting with the IRS. That’s not necessarily good news. Taxpayers often are confused by IRS correspondence and with such audits don’t have the benefit of working with one single agent, the National Taxpayer Advocate says.
But the risk of an audit skyrockets for some. Fully 12.5% of taxpayers whose income topped $1 million faced an audit. And self-employed people who filed a Schedule C with gross receipts of $100,000 or more faced an audit rate of about 4% — four times higher than average taxpayers.
Here are seven red flags:
1. Schedule C
Sole proprietors filing a Schedule C can reduce their audit risk by sticking to the facts — or at least making sure their expenses and income are not dramatically different from similar businesses.
For example, one Chicago-based hot-dog-stand owner said his cost of goods sold was 50% of gross receipts, said Robert McKenzie, a partner in the law firm Arnstein & Lehr. “I know Chicago hot dogs are great, but he had a high cost.”
The IRS found the hot-dog salesman was reporting his expenses but only part of his revenue. He faced “a lot of tax and penalty,” McKenzie said.
Check out BizStats.com for an idea of whether your numbers are out of line; McKenzie said the IRS tells its agents to review that site for average business costs.
2. Rental losses
If you show income from your job or business and claim rental-property losses, be wary. The IRS rules limit deducting those losses in the current year, unless you prove you’re actively involved in managing the property.
“It’s a real hot item right now: Audit people who make significant income from their jobs and also claim rental losses,” McKenzie said.
In one case, the wife of a real-estate attorney — a stay-at-home mom with three young kids — managed the family’s rental properties, but the IRS said the couple couldn’t deduct rental losses in the current year. On appeal they won their case, McKenzie said.
“We were able to prove yes, he couldn’t have devoted 50% of his time [to the rentals] and made $600,000 a year, but she could,” he said.
3. Over-the-top deductions
Taxpayers who claim large deductions attract attention. “Anything that is significantly above what persons in your income bracket might deduct is likely to be looked at,” McKenzie said.
For example, claiming $30,000 in mortgage interest on a $60,000 salary. “Is it because I’ve had a bad year in income, or is it because I really manage my money well and I live modestly except for my very nice house, or could it be I’m earning more money than I’m reporting?” he said.
Got records to back up your claim? By all means take the deduction. “The mantra I preach to my clients is keep good records,” said Audrey L. Griffin, an enrolled agent in Centerville, Ga. “You’re going to get the best possible, honest, legal result and you have nothing to fear.”
CCH Inc., a Wolters Kluwer business, publishes average amounts for some popular deductions. See the CCH page.
4. Business or hobby?
The IRS may decide your business is a hobby — especially if you have other income sources. For example, McKenzie said, the IRS disagreed with an executive who, in addition to his annual salary of $500,000, deducted expenses for his yacht, claiming it was a business charter operation.
In another case, a young man with annual trust-fund income of $300,000 decided to become a race-car driver. He wrote off his costs, including the car, maintenance and the like.
In both cases, the taxpayers settled with the IRS for a partial write-off, McKenzie said. “The bottom line is, the IRS originally challenged these guys making a lot of money but also showing losses on Schedule Cs.”
5. Business use of a car
Griffin’s clients often insist that 100% of their driving is related to business and thus their costs are 100% deductible, but when she digs deeper she finds they often use that same car for nonbusiness purposes.
“Then it’s not 100%, which is the reason the IRS requires you to keep mileage records — date of trip, purpose of trip and the mileage,” she said.
You can choose to use the IRS’s standard mileage rate or track your own, but either way, keep a mileage log and record your expenses, she said.
6. Home-office deduction
You may be able to claim a deduction for expenses related to your home office, including home-insurance and utilities costs, but be prepared for the IRS’s attention.
“I would not discourage a client from taking that deduction if they qualify. I just try very hard to make sure they know the requirements and keep good records,” Griffin said.
Claiming a section of a room is possible — says a corner of the guest room that’s dedicated office space. If “nobody does anything personal in that corner, then that little bit would qualify,” Griffin said.
But is it worth it? You would claim a deduction for a percentage of the housing expense related to the square feet of office space divided by the home’s total square footage.
“It may be a very small percentage and it may not be worth raising this red flag,” Griffin said.
7. Earned-income tax credit
Among people who claimed the EITC — a refundable credit worth up to $5,751 in 2011 for moderate-income taxpayers — 2.2% of returns filed in 2010 were audited.
There’s a “high level of noncompliance,” McKenzie said, often because fraudsters exploit this benefit to line their own pockets.
For instance, scammers will provide an extra Social Security number so taxpayers can claim an extra dependent — and increase their credit.
This is a valid tax credit — just mind the scams and tell the truth.
Another tip for investors in general: When you get your Form 1099-B, “Pay close attention to Box 6,” Hill said. “If this box is checked, that means they were not covered transactions” — that is, the broker is not reporting the cost basis for those transactions to the IRS.
“The IRS instructions are, if that box is checked — even if the broker tells you what the basis was — don’t put it in Category A” on Form 8949. “Put it in Category B,” she said. Other transactions that fall into Category B include those related to mutual funds, exchange-traded funds, stocks that were not purchased in 2011, and stocks that were not purchased at the brokerage that sold them, she said.
Some say taxpayers won’t be that hindered by the new cost-basis reporting rules. “Even before, on Schedule D and the supporting Schedule D-1, you were always supposed to report the basis on it, so in that sense it’s not a huge additional reporting obligation,” said Mark Luscombe, principal tax analyst with CCH Inc., a Riverwoods, Ill.-based tax publisher and unit of Wolters Kluwer
“It’s pretty much the same information but you have to go to a different form to put it on and then transfer it back,” Luscombe said. “If you’re using software it probably doesn’t matter much. It might be just more complicated for paper filers.”
For its part, Intuit said TurboTax Premier does provide guidance on the new Form 8949.
Some brokerages say the new rules eventually will make it easier for investors to report their capital gains and losses.
“These changes will lessen the burden of cost-basis reporting for investors because we’ll handle it for them,” said Felix Davidson, managing director of operations at TD Ameritrade, in a recent press release. “But, we know there will be questions, so we’re doing all we can to help educate clients and make this transition as simple as possible.”
For financial advisers and tax pros, the new rules are creating extra work, and some headaches. “We hired another CPA just to sort out and reconcile our portfolio reporting software with our custodian,” said Brooks Mosley, a certified public accountant and president of Ballew Russell, an investment advisory firm in Jackson, Miss.
“I don’t think the amount of tax that’s going to be collected as a result of [the new rules] is going to be significant compared to the amount of work,” he said.
Plus, the fact that the new 1099-Bs don’t have to be mailed until Feb. 15 — two weeks after the Jan. 31 mailing deadline for most other types of reporting — means that more taxpayers will file for extensions.
“CPA firms won’t have all the data, which means they are two weeks further behind on preparing tax returns,” Mosley said. “I bet there are more extensions this year than there have been in years gone by.”
Go to this IRS page for more on the cost-basis reporting rules.