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How ‘audit-proof’ is your tax return?

by on
in Employment Law,Human Resources,Small Business Tax,Small Business Tax Deduction Strategies

The numbers are deceiving: IRS gum-shoes audited only 0.57 percent of individual tax returns in fiscal year 2002. The rate isn't much higher (only 1.45 percent) for Schedule C filers with incomes above $100,000.

But the free ride is over. The IRS began revving up its audit machine last year as it recovered from budget and personnel problems. So while taxpayers who played "audit roulette" in recent years were fairly safe, the battle has been joined in 2004.

Advice: To make sure your 2003 return flies under the IRS radar, know the key 'red flags' that catch auditors' attention. When such red flags are unavoidable, just make sure you keep your recordkeeping solid.

5 business-return 'red flags'

1. Failing to match up K-1s, 1099s. Last year, the IRS began matching Schedule K-1s—which report income from S corporations and partnerships—to owners' returns. So it's especially vital this year to reflect the correct K-1 numbers on your return. Also, cite every Form 1099 you received (including reinvested dividends) separately on your return; don't group them together. IRS computers match 1099s with information supplied by financial institutions. One mismatch and your whole return opens up for inspection.

2. Business owners who don't itemize. If you're in business for yourself, itemize your deductions on Schedule A. You'll ask for trouble if you report high gross income from the business, show a small profit and take the standard deduction. The IRS may believe you're "burying" nondeductible personal expenses in the business write-off numbers.

3. Big T&E write-offs. IRS auditors know that many taxpayers try to deduct personal expenses as business costs. To avoid problems, follow the three R's: recordkeeping, recordkeeping and recordkeeping.

4. Losses from sideline businesses. The IRS is going after businesses that rack up tax losses year after year by trying to characterize them as nondeductible "hobbies."

5. High-income profession, low-income return. The IRS casts a suspicious eye if you're in a profession that's publicly perceived as high-income (such as a doctor), yet your return only reflects marginal profitability.

5 personal-return 'red flags'

1. Skewed 'money-in/money-out' ratio. Make sure your reported income is sufficient to support your claimed exemptions and deductions.

2. Unusually high itemized deductions. If your itemized deductions—medical, tax, interest, charity—are way off the national averages, IRS computers may want to know why. Be ready to show records if you're outside the lines. (See 3/8/04 issue for most recent averages, by income category.)

3. Rounded-off write-offs. The IRS permits you to round off figures to the nearest dollar, but don't round off deductions to the nearest hundred or thousand. Round numbers make it appear that you are "guesstimating" the figure.

4. Unique tax shelters. For the IRS, 2003 was the year of the tax-shelter crackdown, focusing on offshore credit cards, abusive trust deals and "Section 861" schemes. As always, if it sounds too good to be true, it probably is. For details on IRS tax-fraud enforcement, visit www.ustreas.gov/irs/ci/tax_fraud.

5. High miscellaneous deductions. To avoid the rule that limits deductions to those above 2 percent of adjusted gross income, some taxpayers improperly shift personal deductions to Schedule C, where they report them as miscellaneous deductions. To avoid the appearance that you're doing that, be sure to break down on Schedule C your miscellaneous deductions, rather than listing a lump sum.

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