Ok, maybe I’d rather go get that root canal done rather than endure the hassle of an IRS audit. I think Jay Leno put it best –

“Worried about an IRS audit? Avoid what’s called a red flag. That’s something the IRS always looks for. For example, say you have some money left in your bank account after paying taxes. That’s a red flag.”

Somehow, I do find much truth in that statement! Well, what is it that triggers an examination (audit) by the IRS? Ha, this ranks right up there with the secret formula for Coca Cola. Who knows? The IRS does not come right out and give the triggers. However, we can only draw conclusions based on our own experiences and those of other practioners. Let’s for right now, just address individual tax returns. Probably some of the more evident reasons are as follows:

- Matching of records – Basically, the tax return does not tie to such items as the W2 or Form 1099. Ok, this is pretty straightforward.
- Income greater than $100,000 – Makes sense to me. Why would they audit someone who has little income other than under the suspicion that they are materially understating income.
- Complex transactions without sufficient explanation or detail – Bigger the deal and complexity, then the greater the opportunity for misinterpretation of tax guidance.
- Unusually large amount of itemized deductions that exceed IRS targets – Meaning stay consistent or at least close!
- Self employed – Yes, these individuals have the potential for abuse of tax deductions and understatement of income. The IRS will potentially look at bank records and perform comparisons to other businesses. Also, have you seen the books and records of some self-employed? Wow, now there is some unintended creative accounting at its best. The result is some crazy Schedule C data. There you have it.
- Significant or continued Schedule C losses – If it is not bad enough that your business sustained a loss, then consider that the IRS may look to reclassify your business to a hobby and thus disallow the loss. They may also take a look at certain expenses and attempt to reclassify them at business start-up costs and thus disallow the current deduction.
- Computer score – The IRS assigns a numerical score to each return to identify those with audit potential that could result in more tax. The selection criteria are not disclosed. This is expected but does not give any great insight. Focus on the items above.

Don’t be scared to take deductions that are valid and that you are legally entitled to deduct. However, I would also tell you not to test the IRS with deductions that are questionable and that provide you only minimal benefit. I offer the following three pieces of insight – 1) file a complete and accurate tax return, 2) for unusual or larger than normal items, include an appropriate and detailed explanation and 3) engage a quality tax professional to assist with your specific situation. These insights will take you a long way toward avoiding an audit, or at least being fully prepared in the event of an audit.

I will leave you with the true reason for IRS audits in a way that only Dave Barry can communicate - “Your federal government needs your money so that it can perform vital services for you that you would not think up yourself in a million years”.

This entry was posted on Thursday, June 22nd, 2006 at 5:56 am and is filed under Individual Taxation. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.