Around tax time, the mere utterance of the “A” word is enough to make even the most honest taxpayers break into a cold sweat. Tax codes are so complicated, and the IRS so stringent, that an auditor could probably find an error or two in almost anybody’s return. But don’t sweat; understanding how the IRS selects tax returns to audits may just decrease your chances of being selected.
Audit Risk Factors
The IRS selects the majority of tax returns to audit in one of two ways—either by noticing something on your tax return that sets off a “red flag” or by random. (In addition to “red flag” returns, a certain number of returns are audited at random every year—no way to avoid that one). You can, however, take steps to avoid having your return flagged for an audit.
The IRS uses a complex, top-secret algorithm called the DIF Score to select returns that have the highest potential of producing additional tax revenue in an audit. (Remember, they’re not just checking in on you to make sure you’re playing fair; they’re checking in to see if they can get more money out of you)!’
The formula compares your tax return to average returns for your occupation, age, income, and geographic location, and any major deviations could make you stand out. For example, if you reported an income of $40,000 and $12,000 in donations to charity, while most people in your income bracket deduct about $200 for donations, you stand a good chance of triggering an audit. Low-income filers who live in high-income zip codes may also be at risk.
In addition to the DIF score, certain categories of taxpayers may have a higher audit risk. This includes:
- Freelancers and the self-employed
- Workers with cash income (e.g., waiters)
- Taxpayers using offshore banks and credit cards (no-brainer there)
- High income filers
How to Protect Yourself
An audit is nothing to worry about if you’ve been honest on your tax returns and have the proof. If you did make $12,000 in charitable contributions, by all means deduct it as long as you have receipts to prove it. The same goes for business/self-employment deductions and personal deductions. Also, if you have an extremely large or unusual deduction, provide a written note or explanation with your return—humans don’t look at every tax return, but they will if there’s a red flag, and a simple note of explanation may be enough to preempt any excess scrutiny.
Finally, some suggest that the later you file, the less likely your return will be selected for an audit. If you are not worried about an audit and are expected a refund, file your taxes as soon as you can. If you are worried about your audit risk, and/or owe any taxes, do not file before the April 15th deadline. Some filers even file an extension every year to reduce their audit risk. (If you do file an extension, remember that you must still pay any taxes due on April 15 or face interest and penalties).
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