The last thing anyone wants to see in their mailbox is a letter from the IRS telling them that their tax return is under examination. This is how the folks at the IRS tries to soften the blow of telling someone that they are being audited. If you were to ask a Revenue Agent why one return is selected for audit and another one isn’t they would tell you that returns are picked for examination at random. But are they really?
The answer to that question is hard to determine. Each tax return is scored using “a mathematical technique used to score income tax returns for examination potential” which is called a Discriminatory Index Function (DIF) score. Of course, the IRS will not reveal the actual method they use to come up with the DIF score. There are some very likely triggers, some of which are:
• Comparing income level with the average income in a specific zip code or area.
• Comparing the taxpayer’s return to other returns with their occupational classification
• Matching income on the return with those from Third Party reporters on W-2 and 1099 forms.
• Returns with Schedule C income, because the IRS has determined that there tend to be more mistakes on this Schedule.
There are also some definite red flags that may result in audits. These include:
• Taking significantly higher than “usual” itemized deductions
• Excessively large charitable contributions
• Losses incurred from rental property and how they are claimed. In other words, you cannot claim a loss for a rental property as a real estate professional unless you actually are one.
• Alimony deduction – does the payer and payee have matching amounts on their returns?
• “Hobby Loss” can be an issue. Typically, if a business is reported on a return and it shows a loss in three of the last five years, the deduction for the loss may be disallowed because it is considered to be a hobby, not a real business.
• Meals, travel and entertainment deductions that are extremely high can be an red flag.
• 100% business use of a vehicle, particularly if the vehicle is the only one available to the taxpayer can be a problem.
• A deduction for a home office (other than using the simplified option) is a red flag. You actually need to have a designated office used only for that purpose.
The bottom line is this – if you have anything that you are deducting from your taxable income, make sure that you can substantiate it. That way, even if you do get one of those wonderful letters in the mail, you can prove that the deduction was legitimate.
CFO Business and Tax Services 