In general, the IRS targets the low hanging fruit, shakes the taxpayer’s tree, money falls and the US Treasury is happy. The taxpayers selected are not happy as they just endured months of stress dealing with the audit, costly professional fees and a likely tax debt that includes interest and penalties.
The IRS has a sophisticated system to find the returns to audit. The primary method for selection is the IRS’ “Discriminant Information Function” (DIF). The DIF scores tax returns and the higher the score the more likely an audit and a resulting tax change on the return. Like the Big Mac special sauce and Coca Cola, the DIF is a trade secret. Although it’s kept secret to prevent abuse, certain “red flags” are captured by the DIF.
From years experience of representing taxpayer’s these are some “red flags” that trigger audits:
- Using a Shady Tax Preparer: There are no magic loopholes, use a respected CPA.
- Using Round Numbers: Do not estimate on your return, use the actual numbers which will not be all round.
- Deducting Large Unreimbursed Job Expenses: The IRS targets this deduction because most employers reimburse employees and taxpayers in general are not diligent at keeping receipts and/or mileage logs.
- Claiming Losses on Hobbies: Example, if you like photography and occasionally sell a few photographs that may be determined to be a hobby as opposed to a business.
- Hide Offshore Accounts: It is not illegal to have an offshore account but it is illegal not to not disclose and report the income from that account.
- Being a High Income Earner: This greatly increases your chance for examination. Just like bank robbers the IRS goes where the money is.
- Other examples include unreasonable deductions in comparison to income, continued business losses, incomplete returns, filing late or not at all, making errors, not reporting all income, significant fluctuations in income or deductions from year to year and having a dime dropped on you from an ex-spouse or anyone that may know you are cheating on your taxes.
Your best defenses in avoiding an audit are to keep accurate records and to hire a reputable tax preparer. If selected for audit, you should consider legal representation.