On Wednesday's The Early Show, financial advisor Ray Martin talks to co-anchor Rene Syler and explains how to avoid being the target of an IRS audit.
Taxpayer audits rose 14 percent last year, and the IRS is stepping up the number of audits it performs on tax returns this year as well. It remains unlikely, however, that you will be a target: the average taxpayer has about a one in 164 chance of being audited. But if your income exceeds $100,000, your chances of being audited increase dramatically: about one in 94 high-income filers will be audited. Martin says it is still a low risk, but it's a 24 percent increase from 2002, and a 52 percent increase from 2001.
The government reports that tax evasion is up -- particularly among the wealthy and business corporations. Martin says the IRS actually cut back on audits in the 90s, but is now trying to step up enforcement of the law through increased audits.
A new report released Tuesday says that the IRS budget can not support the staff it needs to continue performing these audits. As a result, Martin believes the government will probably begin focusing more of its resources on those in higher income brackets, which means they will likely remain targets for an audit.
The thought of being audited immediately conjures up images of IRS agents pouring over piles of dusty documents while you stand by, nibbling your nails and fearing the worst. According to Martin, the majority of audits are Correspondence Audits, which aim to fix simple errors. In these instances, a computer will notice an error on your tax form and generate a letter, identifying the error and asking you to fix it or possibly to send in some supporting documents.
A smaller percentage of audits require you to provide detailed documentation to support information on your tax return.
Yet, if you're like most taxpayers, you still want to do all you can to avoid scrutiny by the IRS. First, Martin says, you should understand how the IRS chooses tax returns to be audited. The government uses several different methods to pinpoint returns. Most returns are chosen by a computer program called the Discriminant Function System (DIF).
This process basically assigns a number value to certain items of the tax return, Martin explains. If the total score of all the values exceeds a minimum set by the IRS, the computer will single out the return for an audit. The return will be assigned to an IRS agent who will check it and determine if the return is worth conducting an audit. This scoring process is a closely guarded IRS secret.
Other returns are selected by comparing your claimed credits or refund with your W-2 or 1099, and still others are selected completely at random.
While the IRS does not reveal why they choose certain filers for audits, there are some well-known red flags.
Taxpayers Earning Over $100,000
Basic Information Is Incorrect: Believe it or not, most audits are triggered by incorrect reporting of social security numbers or income.
Married Filing Separately: The IRS finds that these taxpayers tend to not report items consistently on both husband's and wife's returns.
Unusually Large Deductions: If your deductions seem large compared to your income, or you claim "excessive" deductions, the IRS may take a second look at your return. How do you know if your deductions are "unusually large?" Tax prep software such as Turbo Tax will tell you how all of the specific items on your return compare to the national average. Your tax professional, if you hire one, can also pull up these averages.
Self-Employed Filers: The IRS believes these taxpayers are most likely to under-report income or abuse tax deductions. You should not be shy about taking the deductions owed to you, but be sure that you can prove your eligibility. For example, many people with home offices deduct a portion of their rent, insurance or electric bills. Generally, a computer set up in the living room does not count as a home office. Martin says you must have a separate office space.
Businesses Targeted by IRS: The IRS has begun training revenue agents to focus on specific fields or "market segments" where they believe tax abuse is higher than average; this is called the "market segment specialization program." If you work in the restaurant industry or an auto repair shop, if you are an attorney or a child caregiver you run an increased risk of audit. This is just a sample of the businesses that are targeted for increased scrutiny. Log on to irs.gov to see if your business is one of the market segments under scrutiny. If so, you can print out tax guides which will tell you what the government is looking for on these specific tax returns.
Donating Car to Charity: In 2000, car donations to charity reduced taxpayer liability by about $650 million. A 2003 study (by the General Accounting Office) found that many taxpayers overstate the value of their cars when donating the automobile.