Hot tips: Avoid the IRS hot seat
5 audit red flags that are likely to catch the eye of the tax man.
NEW YORK (CNNMoney.com) -- More Americans than ever before are being audited, as the Internal Revenue Service is working hard to collect every single greenback it can.
The total number of individual returns audited last year increased 7% from 2006, shooting to 1.38 million from 1.29 million.
Tax audits, in which returns are scrutinized to ensure accuracy, are an attempt to account for the shortfall in government income from taxes. The IRS recently estimated the gap between what taxpayers owe and what the government actually collects to be roughly $312 billion to $353 billion per year.
The IRS keeps its formula for auditing, also known as the Discriminate Information Function System, under lock and key.
While you may not know exactly what prompts the IRS to pull your return out of the stack, a few factors can increase the likelihood that the tax man will take a second look.
A high income ups your odds of catching unwanted attention, and the deeper your pockets get, the more attractive you become in the eyes of the auditor.
In 2007, the IRS audited 29.2% more individuals making over $200,000 than it did in 2006. And for those lucky few, one out of every 11 individuals with incomes of $1 million or more faced an audit last year.
The more money you earn, the higher the chance that you have some mistake in your reported income, and the more valuable that potential miscalculation is to the IRS.
As John Hewitt, CEO and founder of Liberty Tax, tells CNNMoney.com, "the higher-income taxpayers have the complexities - they have businesses, rental property, a variety of items - not just a tax payer with W2 and no deductions. What are you going to find on that?"
Steep expenses are another factor that will send a return under the magnifying glass of an auditor, says Hewitt. If anything seems excessive, the IRS will take a closer look.
"When you have high expenses, include explanations. Explain why this is not unusual given the circumstances," Hewitt recommends. "If you had a medical expense over say $50,000, include hospital bills. If your house burned down, show a newspaper article, perhaps a bill of how much it cost to rebuild your house," he said.
A carelessly finished return, either incomplete or hard to read, is an invitation to the tax man. An organized return prepared on the computer eliminates the possibility that a number is illegible, and tax preparation software reminds you to fill in each box and checks for errors.
"If someone is handing in a return done by hand - that is a red flag," says Alan Straus, a tax attorney and certified public accountant in New York.
Messy returns are more likely to contain errors and holes. Even a simple oversight means that an auditor has to examine the return in order to correct the mistake.
While you take great pains filling out your deductions, don't forget the simplest details. "Make sure you sign your return. If you don't, they will take a second look. Be precise," said Maureen McGetrick, tax partner with BDO Seidman.
Donating to charity is admirable, but be sure that you're careful when you declare your donations as deductions. Year after year, the IRS looks at the charitable donation deduction with unscrupulous attention.
"It is really unusual for people to give more than 10% of their income - 10% is an extremely large number. The average is really about 2%," Straus said.
McGetrick also noted that in particular, donations of property can throw up a red flag. If you donate something like a used car, for example, be careful. "Any non-cash gift over $5,000 that you give to a charity, you have to have an appraisal," she said.
Previously, small contributions to a charity were allowable on your deductions even without documentation. But as of the 2007 tax year, the IRS requires that all charitable donations claimed as deductions are accompanied by written verification, like a letter from the charity or a record from your bank that confirms the payment.
Self-employment business deductions are another consistently dangerous area on the tax form. So while you may work in your pajamas, think twice before you declare your newest silk set a business necessity.
Home office expenses are automatically a red flag for the IRS, says Martin S. Kaplan, a CPA and the author of What the IRS Doesn't Want You to Know. If it seems you are covering personal expenses with illegitimate home office deductions, an auditor may try to challenge your business practice in an interview.
Kaplan advises clients who run a home business to be moderate when estimating the square footage of their home office and the percentage of their home expenses that they write off to the business. Having very detailed logs and organized receipts, he says, can help keep the auditors away.