Despite the American Taxpayer Relief Act of 2012 passed in January, the government is still tasked with how to cut spending and reduce the deficit.
As a result, Certified Public Accountant David Wolfson, a partner in the accounting and consulting firm Schulman Lobel Wolfson Zand Abruzzo Katzen & Blackman LLP, predicts that the Internal Revenue Service (IRS) will be on the lookout for tax errors: “There will always be more audits (deserved or not) in a down economy, as a cash-strapped government seeks to raise funds.”
Though the 2013 goal for taxpayers may be how to legally reduce more of their tax burden in lieu of higher taxes, there’s a fine line between legal tax maneuvers and suspicious claims that lead to a tax audit.
Here is expert insight into five common tax filing practices that might invite you into the unpleasant world of tax audits.
1. Filing the old-fashioned way.
While completing your tax returns with a pen and hard copy tax form is perfectly legal, Kathy Pickering, executive director of The Tax Institute at H&R Block, cautions that handwritten returns raise a red flag to the IRS. That’s because simple miscalculations and human errors, like putting the wrong number in the wrong box, happen far more often than when technology is used.
According to Pickering, approximately 9.4 million taxpayers made math errors on tax returns for the 2010 filing year, and more than half of those resulted in a larger refund from the IRS. Remember that filing electronically needn’t be expensive, and could actually expedite the process of receiving a tax refund—especially if you’re among the earlier filers.
Beginning January 31, the IRS will open its Free File for taxpayers with an adjusted gross income of less than $57,000. If your income exceeds that amount, costs to prepare your tax filing are tax deductible, whether you choose an accountant or online service that handles more than basic calculations.
2. Trying to game the system.
Taxpayers who generate all their income from a salaried W-2 reported role generally have a fairly straightforward tax filing process. But for less traditional workers, like independent contractors with multiple income streams, employees who make income from cash-based gratuities and odd jobs, and entrepreneurs, the process of keeping track of where income was generated can be daunting.
The headache deepens if a client or vendor sends a 1099 or similar tax form after you’ve already filed, leaving you with the burden of filing an amended and corrected return. But, unless you want to hear from the IRS, keeping diligent records and honestly reporting your income are the best ways to avoid an audit. Pickering says almost 4 million taxpayers received notices saying that they under-reported income in 2010, resulting in an increase in tax liability and additional tax and penalties.
Though what really triggers is an audit is a mystery to some degree, Pickering explains that document-matching programs allow the IRS to check income reported on tax returns against what is reported on forms like a W-2, 1099-INT, 1099-DIV, and 1099-B.
With such a program, the IRS is able to compare taxpayers' deductions with others in the same income bracket in order to assign a score to each return. Items used in the comparison include things like mileage, charitable donations, and other deductions. If a return includes such items that are not in proportion to income reported, it’s an inconsistency. In turn, that return gets a “high score,” and could be flagged for an audit.
3. Claiming a credit you don’t deserve.
The Earned Income Tax Credit (EITC) is designed to help lower to moderate income taxpayers reduce tax burdens and possibly even get money back, if the EITC exceeds the amount of taxes owed. But attempting to reduce your income by taking a slew of deductions, or not claiming income that is subject to tax in order to qualify for credit will cost you far more in the long run. Pickering says that EITC audits made up more than 30% of all 2010 individual audits.
4. Misunderstanding rental income.
Riding out the housing market slump by renting your property? Rental property owners are required to file a Schedule E, and it’s critical you understand the nuances behind it. Wolfson explains that real estate rentals tend to reflect losses due to depreciation write-offs, and that most of the time, those losses are limited on an individual's tax return — unless he or she qualifies as a real estate professional.
He explains that many taxpayers take the losses on their individual tax returns, and as a result, get audited. To limit audit risk, Wolfson suggests either forming a Limited Liability Corporation (LLC) for rental operations, or ensuring that you understand the IRS criteria around participation: You must devote at least 500 hours toward the rental property in order to take deductions on the property, or invest 750 hours to managing the rental, to be considered a real estate professional.
5. Assuming your small business is too small for an audit.
Wolfson says that the IRS has always viewed Schedule C filers with close scrutiny—especially those with gross incomes of more than $100,000, who have a five times greater likelihood of being audited than those who do not file a Schedule C.
To mitigate audit risk, he advises such filers to incorporate, and separate personal and business finances properly. Other audit “red flags” for small business filers include income that varies greatly from year to year, and having employees — including 1099 and freelance workers. Even small businesses that don’t generate a lot of income aren’t exempt. Pickering says businesses with a high volume of cash based transactions are at a greater risk of audit, as are Schedule C filers with numerous years of losses.
When using a Schedule C to properly report all income, Pickering says to deduct only the expenses entitled on the Schedule C, which includes costs related to advertising, insurance, legal services, vehicle expenses, employee wages and taxes, home office expenses, and depreciation. If you can’t substantiate a business expense with backup documentation, you might be playing with fire.
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