Editor's Note: Learn from a panel of experts and entrepreneurs who have successfully financed their own ventures and are helping others do it at the Thought Leaders Live 2013 event May 29, in Long Beach, Calif. Event and ticket information can be found here.
Taxes are a necessary evil--the price we pay for roads, bridges, schools and law enforcement. Audits, on the other hand, feel just plain evil.
In an effort to thwart fraud, the Internal Revenue Service audits about 1 percent of U.S. taxpayers every year. IRS computers are programmed to catch outliers and oddities on returns; any item that falls outside the norm may be flagged so that an IRS employee can review it to see if there's actually a need for an audit. Common red flags include:
Incomplete or sloppy returns. Math errors and missing information make the IRS cranky. If the agency's computers can't make sense of what you filed, your return will be rejected. Eyebrows will be raised if the numbers on your state return don't match those on your federal return.
Unreported income. Obvious, but worth repeating: If you file a return but don't report all your income, you're asking for trouble. You have to report all your interest, dividends and other income, even if you were paid in cash.
Abnormal income. If your income is suspiciously high or low, you're much more likely to be audited. If your income fluctuates significantly from year to year, that may raise a red flag, too.
Numerous itemized deductions. There's nothing wrong with claiming all the deductions to which you're entitled, but be aware that if you claim more than average, you'll have a more than average likelihood of being audited.
Being self-employed. That's the biggie for entrepreneurs. Filing a Schedule C ("Profit or Loss from Business") doesn't guarantee you'll be audited, but if you've got a small business that is showing losses year after year while you still hold a day job, the IRS may consider that business your hobby. Home offices and unlikely business deductions may also be red flags. Don't be afraid to report actual expenses, but make sure you have documentation for why that Jet Ski is a legit deduction.
Other common tip-offs include large charitable contributions, business meals, entertainment expenses and claiming a vehicle exclusively for business use.
Your best defense against an audit is old-fashioned honesty. Save your receipts, report all your income and don't fudge things. Use tax-preparation software or hire a professional. But even if you have a pro prepare your return, review it for obvious errors, because nobody cares more about your money than you do.