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Every year, the Internal Revenue Service audits approximately 1 percent of U.S. taxpayers. Though the odds are slim that your return will be singled out, they increase dramatically if you run a cash business like a bar or restaurant, take a home-office deduction, make large charitable contributions or work for yourself. Like to splurge on fancy cars, boats or home improvements? Living large without documenting your income can raise red flags, too.
Deductions and expenses that are disproportionate to the taxpayer's income catch the IRS' attention, says Mitchell Eichen, a tax partner at Perelson Weiner, a New York City accounting firm.
No matter what kind of business you run or how many deductions you take, you can lower your chances of being audited by following these steps:
Keep accurate books. The IRS is on the lookout for businesses that deal heavily with cash. No law says your business must accept checks or credit cards, but don't assume that you can put the money in your pocket and the IRS will never know. The same goes for businesses that do a lot of barter, and for contractors who take side jobs, helping friends and neighbors. The IRS can quickly compare your business income to your living expenses and figure out if you're living beyond your documented means.
Deduct within reason. Writing off too many business-related expenses can put you in the IRS' line of fire, especially if the income you report is relatively modest. An IRS computer program compares your deductions to others in the same income bracket (the so-called DIF Score) and selects the returns with the highest probability of generating additional audit revenue. "A decision to forgo a legitimate deduction may be based on the taxpayer's particular audit tolerance or if there are other areas of the return that the taxpayer does not wish to call attention to," Eichen says.
Check your math. A couple of mistakes in calculating deductions won't automatically catapult your return to the top of the IRS pile, but too many mistakes in your favor may trigger an audit. If you receive a 1099 from a company for freelance work that you performed as an independent contractor, be sure to enter the exact amount on your tax return. Because the company that hired you also sends a copy of the 1099 to the IRS, the slightest discrepancy between the two numbers could set off alarm bells.
Back it up. It's important to keep good records in case the IRS does come knocking. Business owners are required to keep receipts for all expenditures of $75 or more for meals or entertainment, and to keep those receipts for at least three years. Good record-keeping is also important if you're planning to take large personal deductions. For example, if you're claiming a large medical or charitable deduction that you think might increase your odds of being audited, make sure to attach copies of your medical bills and charitable receipts to your return.
Get professional help. If you already have an accountant or tax professional who prepares your business return, it's a good idea to let the same practitioner prepare your personal return as well. Not only will you avoid some of the common tax preparation mistakes, but you'll also have an advocate to go to bat for you if you do get that dreaded letter from the IRS. If your tax preparer did a competent, professional job of reporting your income and deductions, you should have nothing more to fear than the inconvenience of responding to the letter and possibly meeting with an IRS agent. "Competent, professional tax advisors will warn you when taking a certain position can heighten the possibility of an audit and when a tax return looks fishy," Eichen says.