5 tax audit red flags

A guide to what the IRS looks out for on returns.

By Christian Zappone, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) -- The IRS conducted 1.3 million audits last year, up more than 5 percent from the year before.

And now, President Bush's recently released budget calls for a step-up in efforts to close the $300 billion "tax gap," the difference between what is owed in taxes and what is collected.

What's more, there are some new rules on the books that could trip up tax filers.

Any way you look at it, more tax audits may be on the way. Here are five red flags the IRS is likely to watch out for this tax season.

Earning too much money

It's a problem most people would probably love to have, but high earners should be aware that they're more likely to end up on the IRS's radar, according to David Sands of Buchbinder, Tunick and Co.

Sands says once an income tops $100,000, the chances start increasing.

The emphasis on flagging high-net-worth filers makes financial sense from the IRS's perspective.

"The IRS is under pressure to close the tax gap," said Bill Stromsem of the American Institute for Certified Public Accountants. "It doesn't pay to find a $100 error in a filer in the 10 percent category instead of $1,000 from someone in 30 percent tax bracket."

In 2006 the IRS audited the returns of 17,015 tax filers reporting income of $1 million or more. That's up 33 percent from the 12,835 audits of million-dollar earners it conducted in fiscal year 2005.

The IRS's audits of taxpayers with reported incomes above $100,000 rose 18 percent in 2006 from the previous year, to more than 257,000 returns.

The IRS declined to comment on the specifics of audit red flags.

Giving too much to charity

Excessive contributions to charity could trigger an audit, too.

Sands estimates that once contributions exceed 5 percent or 10 percent of income, that may raise questions.

Complicating matters is that this year the rules related to deductions for charitable giving have gotten stricter, with the IRS demanding more documentation. Sands says there is a feeling there has been "some abuse in this area" in recent years.

Taxpayers will have to keep a qualified appraisal of donated clothing and household items that exceed $500.

They must have a receipt or bank record that shows the name of recipients of financial donations. For most taxpayers this change only applies to contributions made after the start of 2007.

Finally, IRA holders older than 70-1/2 years can directly transfer up to $100,000 tax-free to any charity, but the funds must be given directly by the IRA trustee to the charity.

Knowing when the alternative minimum tax applies to you

Taxpayers can be subject to the alternative minimum tax and not know it. Failing to submit an AMT schedule when you are in a high-risk group may grab the IRS's attention.

Some people aren't attaching an AMT schedule and are subject to it, according to Sands. Those that fit the AMT profile: High earners in high-tax states.

Sands puts the threshold for a filer entering the AMT category at about $100,000-$120,000.

Stephen Buschel, tax partner at BDO Seidman, calls the AMT "an insidious tax because you never know when it's going to hit."

The AMT aims to collect taxes that are lost when filers use so many deductions they pay no taxes at all. This is because while the tax was invented in 1969 to prevent wealthy filers from avoiding taxes through extensive deductions, it has never been adjusted for inflation, and so it captures ever more filers lower down on the scale.

When a return is filed, the IRS will do the calculation to see if it qualifies, said Buschel.

Taking too many credits

Tax credits are another area of concern, especially for people at the lower end of the income scale. The biggest mistakes are made with earned income credits, according to Sands, who cites a general confusion about credits for education, seniors and earned income.

"I can understand why it's very confusing," said Sands, pointing out that people often take credits they're not entitled to.

He suggests that lower-income filers use the IRS's walk-in services. A Volunteer Income Tax Assistance Program has been set up to help low- to moderate-income filers who cannot prepare their own returns.

There is also the Tax Counseling for the Elderly Program, which offers help to filers 60 years of age and older.

Careless errors

Things as simple as a sloppy return can derail an otherwise routine tax return. Matters as small as incorrect Social Security numbers, math errors or simple misspellings can bring a tax return to the attention of the IRS.

"There's no excuse for that. Just show a little care and get your material together," Stromsem remarked.

He also pointed out that banks and brokerage houses send in reports of your 1099, which the IRS will compare. "If you forget a 1099, it will cause the IRS to pull it out of the pile."

The best way to lower your odds further is by following the advice of IRS spokesman Robert Marvin: "Taxpayers should take deductions and credits that they are legitimately entitled to and that make economic sense," Marvin said. "They also should keep accurate books and records."

For filers who do that, not even an audit should scare them.


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