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Fewer IRS audits doesn't mean you're home free

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Latest MoneyWatch headlines 01:08

For the fifth year in a row, IRS audits of individual tax returns have declined. In 2010, the chances of having your return selected for audit was one in 90. In 2016, that fell to one in 143, the lowest since 2003. 

Audits have tumbled even for higher-income taxpayers. Last year the IRS audited just 5.8 percent of the returns that included income over $1 million, down from 9.6 percent in 2015.  

The reason for shrinkage in audits -- a primary IRS enforcement tool -- is that the agency is too short-staffed. Over the past several years, Congress has been freezing and cutting the IRS’s budget in the wake of the agency’s abusive targeting of political groups. This occurred at a time when the agency’s workload climbed due to tax code changes and a surge in fraud and identity theft.

The result has been a perfect storm of controversy, external attacks and increased workload, so something had to give.

Tax return red flags to look for to avoid an ... 02:00

Incoming Treasury Secretary Steven Mnuchin voiced his concern about the decline in resources at the IRS and said he’ll make a case to President Trump that increased spending on tax enforcement could yield more in taxes collected. Past estimates have shown that for every dollar the IRS spends on audits, it collects $4 to $6 in tax revenue.  

So while the chances of having your tax return audited may be low now, it could go back up as the problem gets more attention. And as always, the chances of an audit can increase substantially depending on your income level, types of income, amount of deductions, your income-earning activities and changes you’ve made since your last tax return.

One of the newer areas getting closer IRS scrutiny is tax returns that include income from a business that accepts credit and debit card payments. Gross and monthly totals received from these cards are reported to the IRS by banks and other settlement entities that process the transactions. So it’s important to make sure these amounts are reported accurately on business tax returns.

Individuals who report investment gains from the sale of stocks or mutual funds should be careful to correctly report the cost basis and proceeds from each sale. That’s because brokerage firms are now reporting the cost basis of sold investments to the IRS, and if you report this incorrectly, your tax return is more likely to be selected for audit.

The IRS also employs software that creates a score for all tax returns based on some specific items. When the total score on your return exceeds the national average set by the IRS, you’ll get singled for a possible audit. The exact items and scoring convention is closely guarded, but here are some of the items believed to be included:

  • Large amounts of income not subject to tax withholding.
  • Unusually large amounts of deductions claimed than seem unreasonable when compared to your income.
  • A large number of dependent exemptions claimed in conflict with reported SSNs, tax withholding allowances, etc.
  • Large deductions for charitable contributions, casualty losses, home office expenses and travel and entertainment expenses.
  • Indicating a change of address when not reporting a sale of your residence and not changing your home-related deductions.  

One of the easiest ways to reduce your chances of an audit is to double-check the information on your tax return. That’s because the IRS runs returns through a process that compares the information you report from your bank, your employer, etc. on forms W-2, 1099, etc. versus the same information on the versions of the forms it receives. 

If you omit an item from your tax return, it’ll be picked up and trigger a computer-generated notice that includes a recalculation of your tax and the additional interest and penalties you may owe.

And remember: An IRS audit isn’t something to be feared. If you’ve kept complete and accurate records of all deductions and reported all your income, you needn’t worry. In fact, in about 25 percent of audits, the IRS either makes no changes or issues a refund. 

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