A “tax audit” occurs when the IRS wants to do an in-depth examination of your income tax return. It will ask for additional documents to ensure that your income, credits, deductions, and expenses are accurate. While you should have good records in the event of an audit, the truth is that many people simply do not keep the documents that they need to show to the IRS. This is an unfortunate mistake that can end up costing you in the event of an audit.
Unfortunately, some completely valid tax reduction strategies trigger the IRS’s attention. Audits are both frightening and intimidating. Avoiding an audit is obviously the best course of action if you can manage it. Good tax planning involves taking steps to dodge an audit.
Measuring Your Risk of an Audit
You may have heard the statistic that less than one percent of individuals are reviewed. In fact, the number has recently been lower for individual taxpayers. Nonetheless, the concern is still very real, and the consequences of a poor audit can be significant.
The occurrence of IRS audits has increased over the past several years. It is no secret that the United States has an enormous fiscal deficit, and one of the many ways that the government is attempting to deal with that deficit is by increasing its collection efforts for taxes. This includes collecting both back taxes and ensuring that individuals and companies are paying the correct amount of tax due. However, in 2017, the IRS’s funding has been decreased significantly, which will likely trigger a decline in audits overall.
The IRS uses a specific process to target taxpayers for audit purposes. Your tax return is essentially run through a program that examines your return and looks for specific “red flags.” These red flags could include certain deductions or credits, or they could include the fact that your income is above a certain limit. It could also include simple things like math errors or numbers that are significantly different than prior years’ returns. Returns that are out of line with national statistics can also trigger a red flag.
Likely Targets for an IRS Audit
Certain taxpayers are at a higher risk of being audited. For example, sole proprietorships and single-member LLCs have a much greater chance of being audited compared to a corporation or an LLC. In fact, usually, these “Schedule C” businesses are the most common audit targets. Other IRS targets often include:
- Those taxpayers that have new businesses operating at a loss (“hobby loss” cases)
- S corporations that do not have any wages being paid out
- Taxpayers that have high charitable donations
- Real estate professionals and property dealers
- Business expenses that include travel, food, automotive, or entertainment
- Tax protestor cases (those that do not feel that the tax system is valid or that they do not owe taxes at all)
- Stock market traders have a higher risk of audit than someone who is just considered an “investor”
- Like-kind exchanges (with specific interest in timing issues)
- Taxpayers that have offshore bank accounts
- S Corporations that fail to designate themselves as S corporations
Of course, those with higher income will also have an increased risk of audit. In fact, taxpayers that have over $200,000 in income are 50 percent more likely to be reviewed compared to lower-income taxpayers. Those taxpayers deal with higher taxes overall, so the IRS gets more “bang for its buck” because the numbers are simply bigger. Companies also generally have a higher risk of an audit than individuals that do not operate a business as well.
Setting Up a Business Entity
Because sole proprietors are so much more likely to be reviewed, it is in your best interest to set up a corporate structure for your business. Of course, setting up a corporation or LLC is also a good idea from an asset protection standpoint as well. In fact, establishing a business entity (other than a sole proprietorship) can be the single most beneficial move you make for your wealth management strategy.
Audit Time Limits
For most taxpayers, the IRS has three years to audit you from the date of filing your tax return. However, that timeframe increases to six years if you have understated 25 percent or more of your income. The longer time limit is geared more toward those who appear to be intentionally trying to evade paying taxes and could be engaging in criminal activity.
If the IRS suspects that you are understating more than 25 percent of your income, there is no time limit (or “statute of limitations”) on the IRS’s ability to audit. Generally, this applies to deliberate, large-scale tax evasion.
Keep in mind that you sign your tax return under penalty of perjury. That is, by signing your taxes, you are stating to the IRS that everything in your return is truthful and accurate to the best of your knowledge. Signing a false tax return is considered a criminal offense, which can result in jail time in certain circumstances.
Record keeping is critical to making an audit run smoothly. However, some taxpayers do not realize just how in-depth an IRS audit can be. Use these tips to ensure that you have your records looking good in the event of an audit.
Receipts and Payment Records. Always, always, always keep your receipts! You should also keep a record of how you paid for the item. The IRS will want to know how you paid for a particular item as well, not just that you did. That may mean keeping bank records, a canceled check, or a credit card statement.
Expense Logs. You should also be sure to keep logs of your meals and entertainment, auto miles, and other travel expenses. The IRS takes a close look at these costs because they are often more susceptible to abuse than other types of costs.
Bank Statements. Bank statements may be vital for businesses as well. The IRS may do what they call a “deposit analysis,” which essentially examines how much money comes in and how much money goes out in comparison to what you reported on your tax return.
Time Limits for Recordkeeping. At the very least, you should keep your records for three years. However, you should keep your tax returns as long as possible (forever!) because there may be situations where you need to show the IRS that you filed your taxes several years ago.
Records for Specific Assets. You should also be sure to keep records regarding any asset that you own, particularly real estate or when you are depreciating an asset. You should maintain records for the entire time you own the asset, plus three years.
Bookkeeping Program. Generally, it is a good idea to have some type of accounting program to help you track income and expenses. Regularly tracking these items will not only assist you at tax time but will also help you keep tabs on how well your business is doing from a financial standpoint. Additionally, it helps you show the IRS that your business is more than just a hobby.
Other Quick Tips to Avoid an Audit
You may be surprised at the small things that can increase your likelihood of being audited. The following tips may be minor, but they can have an effect on whether you will go through an audit.
- Don’t use rounded numbers for your expenses. If the IRS sees several rounded numbers, that may mean that you do not know what the numbers are or you are just making them up. Always use numbers that are supported by actual records and receipts.
- Always maintain a separate bank account for your business. Keeping a separate bank account makes the IRS think that you are serious about your business and it is more than just a hobby. It is also good practice for asset protection purposes as well.
- Hire a professional. If you are unsure of what tax laws you can use to your advantage, it is always a good idea to ask a professional for help. Talking to a professional may cost you a little now, but save you thousands in the future. You do not want tax savings now to cost you more in the long-run.
- Be careful with the cost basis for stocks. You should know when a stock was purchased and how much the cost was (purchase plus commissions and adjustments) when you are reporting the sale of stock to the IRS. The IRS can easily verify this information, so be sure to get it right.
- File an extension. If you request an extension to file, you can decrease your risk of being audited. By the time you turn in your return, the IRS has already determined who they want to review, so your likelihood of being targeted significantly decreases.
- Provide explanations. If you have something unusual going on with your income or deductions, it does not hurt to provide a comment or explanation on your return (such as when you received a 1099 personally, instead of something that should be attributed to your business income).
Keep in mind that you should be able to take every deduction and credit available to you. While certain tax reduction strategies may increase your chances of an audit, if you are being truthful and have good books and records, you should not have any real concerns.
You can learn more about these tips and many, many others regarding tax savings, tax planning, and overall wealth management by using the extensive resources that Protect Wealth Academy has to offer. Take advantage of the free membership – sign up today.