The IRS has audited tax returns the last several years at a historically low rate. Individuals faced a 0.84% audit rate in 2015; millionaires, 9.55%; Schedule C sole proprietor taxpayers, 4%; partnerships, 0.51%; and S corporations, 0.40%. (Source: The Kiplinger Tax Letter: Vol. 91, No. 4) None of this makes a difference if your number comes up. Over the years I developed methods to reduce risk of audit. My clients are audited at a fraction of the national rates due to the steps applied to all tax returns leaving my office.
IRS audits are expensive even if you did nothing wrong. Hiring an accountant to navigate the audit process is time consuming regardless of guilt. Unlike criminal law, in tax matter you are guilty until you prove yourself innocent. The burden of proof is on you to provide proof of income and deductions should the government come knocking. Below are several tips to reduce your risk of getting an unfriendly letter from Revenue.
Mechanics of a Tax Return
There are a million ways to prepare a correct tax return; some lead to audit. Big numbers in certain places on a tax return invite the IRS to take a look. It is easiest to illustrate using a sole proprietor’s Schedule C.
First, miscellaneous expenses should be a small number. If you have a large amount of miscellaneous deductions, break it up and add the expenses to another line deduction or list separately.
Second, large numbers on certain lines are acceptable, other lines, not. A salesperson on the road a lot will have a serious mileage deduction. An office will have more office expenses than a construction business. Whenever possible, break up large numbers into smaller categories of expense. It is reasonable to break out postage as a separate expense from office supplies, especially if you are using mail marketing. Some of the postage expense might fit as an advertising expense.
Next, businesses that create things (home builders, drywallers, concrete, et cetera) will have a large cost of goods sold. I like to add as much here as possible since the number is expected to be large. Adding expenses to COGS can clean up a tax return that in hard to interpret without an audit.
Show the IRS It Is a Mistake to Audit You
Once you break up large numbers that draw attention, it is time to address large numbers that have to stay in one spot, tax positions you take in gray areas, and clarifying unclear areas of the tax return. There is nothing wrong with a large deduction. There is nothing wrong with using a tax strategy to reduce your liability as long as you have something to hang your hat on. Tax professionals risk penalties if they take an unreasonable position. But even reasonable positions sometimes draw unwanted attention. There is a way to convince the IRS you did the research and are not low-hanging audit fruit.
Form 8275, Disclosure Statement, is the most underused form the IRS has. Most tax professionals never used Form 8275 in their career. It is a shame. Form 8275 is used to inform the IRS you are doing something that may concern the IRS or to disclose a position you are taking in a gray area of tax code. Some people feel telling the IRS what you are doing invites an audit. Quite the contrary. What it tells the IRS is that you did the research and if they decide to audit they had better come prepared. I have never, in over thirty years of practice, ever had the IRS audit a tax return with a filed Form 8275! Since the form is only used for extraordinary circumstances this is an enviable record.
Here is an example of an audit waiting to happen, averted. A client donated over 100% of his income to charity one year. That is a really big number. You can only deduct 50% of your income on Schedule A if you itemize, the remainder carrying forward for up to five years. With such a large deduction I was certain an audit was inevitable. I attached Form 8275 informing the IRS my client donated such a large amount because he received a large inheritance and wanted to give back to the community. I scanned and attached documentation proving the deduction. This client has a complex return and I avoided an audit on the whole thing by disclosing one item sure to trigger an audit.
Any time I have a large number or take a position that is unclear by looking at the return I attach Form 8275. The form is simple to prepare and you do not have to fill in each line (i.e. the Revenue Ruling used, if any). A simple description of what you did, and where on the tax return, solves a lot of problems before they begin. When in doubt I file Form 8275 along with supporting documents. An auditor receiving the tax return for review can close the file before wasting any of your time.
Back in 2010 I wrote a 10-part series on the IRS audit process from beginning to end. Rather than re-write the whole thing, I included the links below for your leisure reading. The audit process has not changed much in six years so the information is accurate. However, HubPages, where I published the articles, has had many changes over the last six years. They have auto-editors changing things once in a while. Just something to consider as you read.
All this audit talk is dry reading until you get a letter from your Great Uncle. It might be a good idea to bookmark this page for future reference.