How to Avoid a Tax Audit

Jan. 27, 2011 -- "I've been audited six times and never paid a penny!" crows Steve, a Manhattan author who, for reasons that will soon be obvious, doesn't want his full name used.

Steve is proud to have gone toe to toe with the IRS six times and, six times, emerged unscathed. While that's sweet satisfaction, avoiding being audited in the first place is sweeter still.

Tax professionals and the IRS agree there are simple steps every filer can take to reduce the odds of being audited. 'Reduce,' though, does not mean eliminate: Some filers are audited entirely at random, so there's no way you can cut your odds to zero.

Report everything you're supposed to, no matter how piddling the amount. So says CPA Michael Schulman, third-generation owner of Schulman CPA, a full service New York City tax, accounting and auditing firm. The IRS automatically gets duplicate copies of all the forms that you receive -- your W2, your 1099, etc. They cross-check them against your return.

"They match everything," warns Schulman. "That $11 you got as interest on some old bank account? Report it."

It's not the amount that matters. It's your failure to file a complete set of documents. The discrepancy, when discovered, will cause you to receive an automatic audit, in the form of a letter from the IRS asking you to explain. You don't' want to call attention to yourself. You want to pass without friction through the system.

Meet filing deadlines. Again, you don't want to do anything to suggest you're being anything less than 100% complaint. You want to make yourself in every way to "look like a normal taxpayer," Schulman says. Remember that even if you file for an extension, by April 15 you still must pay any taxes owed. Not sure how much you owe? Can't afford to pay the full amount? Experts advise you to pay something, even a token amount, as a gesture of good faith. Some preparers recommend you file as late as possible, on the theory that, in a given tax year, most returns that get audited are selected prior to October 15, the last extension deadline.

Don't be a pig. "People have a tendency to be too generous with their deductions," says Schulman. "Only deduct what you're entitled to — your unreimbursed business expenses, for instance." Unsure how much is too much? Some consumer tax-prep software comes with a feature that automatically flags amounts that fall outside IRS norms. If you're tempted to claim a deduction for a home office but unsure whether or not you qualify, consult IRS Publication 587.

Be prepared to document all expenses and to prove how they relate to your business. Steve, the author and six-time audit veteran, legitimately wrote off his research costs for a non-fiction book, but without yet having any royalties to show from the project. He was, however, able to show the IRS that he was a published author and had earned royalties before. His receipt-keeping and record-taking were impeccable.

Choose your preparer carefully. According to the most recent report by the National Taxpayer Advocate, 60 percent of individuals use paid preparers to do their taxes (the percentage for businesses is higher). Since you, not the preparer, are legally responsible for what's submitted, you want to make sure the professional you use is ethical and skilled. Go to the IRS' website for a list of eight points to keep in mind before making a selection. These include checking with the Better Business Bureau to see if your preparer has any complaints against him. You also can check with the IRS' office of Professional Responsibility to see if the IRS ever has disciplined him.

Michael Dunworth, a tax attorney with Pryor Cashman LLP in New York City, says you should steer clear of anyone who promises to work miracles. "If you've had a big gain or received some big slug of income, and somebody claims they can just make it go away, you've got trouble right off the bat," he cautions. "When there are big offsets against big gains, that's a red flag for the IRS. Avoid anything that looks questionable or shaky."

Don't file Form 5213. If you've turned a hobby into a business, you might be tempted to file this form ("Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit"), which, in effect, tells the IRS to chill out for five years until you can prove that your venture is capable of making profits. The joker is that by filing this form you all but guarantee yourself an audit at the end of the five years. Better solution: Document that your venture has the potential to make money. Be able to show, for instance, that there are other people doing it for a profit; that you posses the necessary knowledge and experience; and that you are putting in the amount of time and energy necessary for it someday to succeed.

Sign your return. Every year, people forget to.

Incorporate. Small businesses are among the IRS's favorite audit targets. A self-employed tax payer filing Schedule C runs a 10 times greater risk of being audited than someone who has incorporated. And if you incorporate, you'll be eligible to claim more deductions.

Explain. Provide information before it's asked for. Schulman gives this example: "Personal legal expenses aren't deductable; but ones necessary for the production of income are. So, don't just deduct legal expenses of $60,000. That will raise an eyebrow. Provide a note explaining that you had to sue, say, to collect payment of fees owed the business."

Show your state tax return the same respect you do your fed. If you're ever audited at state level for having failed to report income — or for any other reason — your state communicates the fact to the feds, which can invite an IRS audit.

Beware whistleblowers. Persons with the knowledge or incentive to rat you out are nicely paid by the IRS to do so. Rewards range from 15 to 30 percent of the amount owed by the tax miscreant (business or individual). So play nice. Don't cheat. And guard your privacy.

Final words of wisdom from attorney Dunworth:

"Don't be doing things just to avoid an audit, because sometimes you could be leaving money on the table. I tell my clients, don't be afraid of an audit. Be prepared for one. Keep good records. Then, if it happens, it should go fairly painlessly."

But don't get carried away: Even Steve drew the line at six.