There’s nothing good about being selected for an IRS audit. At best it’s a time consuming nuisance, and at worst you’ll be poorer in the end. But you can reduce your likelihood of being audited, or if you are selected, of being billed.

There are three types of IRS audits. The simplest and most common is a correspondence audit, where the IRS mails you a request for further information about one or more items on your return. In most cases the issues can be resolved by responding with the appropriate documentation.

If you’re selected for an office audit, the IRS will schedule an appointment for you to meet with an auditor at their local facility. They’ll tell you in advance which specific areas of your return(s) will be addressed and what types of documentation you should bring in.

A field audit is more comprehensive. An IRS agent will travel to your home, business, or representative’s office, review the returns at issue, request documentation for questioned items, and ultimately issue a report either recommending a tax change or accepting the returns as filed.

The Selection Process

Correspondence audits are often triggered by information matching. The IRS receives W-2s, 1099s, and similar reports from businesses and financial institutions and matches the numbers to the tax returns filed by the individuals involved. If the returns don’t agree with reported figures, the individual will be asked for an explanation and/or simply mailed a bill.

The IRS also uses a computer scoring system to select audits. Based on past experience, the system assigns a score to each tax return indicating the likelihood that the tax was understated or certain income was not reported. Common red flags include the following:

• Disproportionately high charitable deductions in relation to income.
• Large deductions for travel, entertainment, and business meals.
• Unusually high ratios of business use claimed for automobiles.
• Unusually high home office deductions.
• Excessive and/or repeated business losses.
• Unreported foreign bank accounts.
• Frequent large cash purchases or deposits (reported by outside parties).
• It’s advisable to be conservative on your tax returns with respect to these “red flag “ areas, although you needn’t forgo claiming legitimate deductions. Be prepared to support your position by keeping meticulous records and retaining every relevant document.

2015 Audit Activity

In 2015, above-average audit activity may be expected for upper income individuals, sole business proprietors, partnerships, and S corporations. Cash-intensive enterprises (bars, restaurants, taxis, hair salons, etc.) are particularly apt to receive a higher rate of scrutiny, as are industry categories that tend to have high rates of deductions not independently reported to the IRS (such as construction and real estate rental businesses).

If you do happen to be selected for an audit, call us. We’re prepared to assist you with whatever is needed.

*This newsletter is issued quarterly to provide you with an informative summary of current business, financial, and tax planning news and opportunities. Do not apply this general information to your specific situation without additional details and/or professional assistance.