Tax Deductions

The Top 10 Ways to Avoid an IRS or State Audit

This time of year, tax returns are on all of our minds. We may want to shop for a "bargain" by taking a write-off (or write-offs) that may be a little too aggressive or questionable. We may want to save the most we can and not pay Uncle Sam any more than we need to. 

But at the same time, we want to minimize our chances of an audit. And that's a sound goal.

Related: Facing an Audit? Here Are Steps to Take When the Tax Man Comes.

The reason is that, as you might imagine, an audit can be expensive and time-consuming, not to mention emotionally draining. Here is a list of the top 10 things to do, and not do, in order to avoid an audit. Take these to heart as you set out to save the most you can in taxes.

1. Keep receipts. 

Receipts have nothing to do with keeping you out of an audit, but they can certainly reduce the severity of one and even reduce the extent and time one might take. Keep the best accounting records you can. This will help you produce a better tax return and more accurate figures, reducing the chances of an audit.

2. File your tax returns on time (even if you owe and can't pay). 

One of the quickest ways to get into an audit is to not file your tax returns. I highly encourage you to still file even if you don't owe anything or don't have any income. The IRS is like a boyfriend or girlfriend: If you don't stay in touch, Uncle Sam will assume the worst. He'll also say bad things about you to your friends.

3. Be aware of your industry averages and common expenses. 

When you file a tax return, you also indicate the industry that you work in. This allows the IRS to categorize your expenses and look for abnormal expense levels compared to your income. Obviously, you would never increase an expense because "it wouldn't be noticed." But you certainly should also consider reducing an expense if it is far too high and will stand out.

Related: So You're Being Audited. Now What?

4. Attach additional statements and comments. 

When necessary, include additional information with your return, to substantiate expenses and oddities that might catch the IRS' attention. If your file gets handed off to an agent for further review, a real human can sometimes choose to bypass your return for an audit because you already provided the support the revenue agent was looking for.

5. Avoid Schedule C. 

Having a small business is a great tax-saving strategy, but reporting it as a sole proprietorship can dramatically increase your chances of an audit. Choose instead to file as a partnership or corporation when that's economically feasible. Make that change this year.

6. Issue your own 1099s.

This is a huge area of concern for the IRS. When you are claiming deductions for paying sub-contractors, you need to issue the proper 1099s in January and follow specific reporting procedures. If you already missed the deadline this year, don't let it happen again. Request W-9s from all contractors before you pay them.

7. File payroll reports and remit your payroll withholding. 

If you own and operate an S-corporation, payroll procedures are critical. If you have employees, don't even get me started regarding your withholdings. This is sacred money in the eyes of the IRS, and you must never get behind on these reports or on remitting withholdings. It's not just an audit we're worried about: We're talking jail time.

8. Avoid round numbers.

This should be a no-brainer, but you would be surprised how many tax returns we review with round numbers. This is a major red flag. How many people actually spend $400 on office supplies in a given year? I don't think you could go through Staples and create one or two purchases that exactly add up to $400 even if you tried. Be accurate and don't forget Rule No. 1 above.

9. Don't inflate the home-office deduction. 

Take the home-office deduction and don't be afraid of it, but also don't get too aggressive. Have a procedure/calculation and remember, "Pigs get fat and hogs get slaughtered." Don't get greedy.

10. Avoid taking excessive dining, travel and entertainment expenses. 

I'm the first to advocate taking a healthy deduction for dining, travel and entertainment. However, these expenses should look normal and well-balanced and conform to your income level and industry. For example, if you run an eBay business out of your basement in the evenings, I don't think daily dining and golfing expenses are going to fly. However, if you are a sales rep on the road peddling products, those types of expenses will appear to be less aggressive and relatively standard.

Bottom line, don't be afraid to take an expense that you're entitled to, especially if you kept good records. But also make sure that you're filing your reports and that your tax return doesn't stand out. This isn't the prom: You want to stand in the corner and not get asked to dance.

Related: Signs That You Are About to Get Audited (Infographic)