True story: When the Internal Revenue Service added a requirement that taxpayers list the Social Security numbers of their dependent children in order to claim a popular tax credit, a funny thing happened. The number of kids listed on American tax forms plummeted from 77 million to 70 million. Now, it’s possible that aliens abducted millions of young earthlings that year, and the government is still covering it up. But I’m going with a different theory. I believe that in random audits, the IRS had caught people taking deductions for children who didn’t exist, so they changed the rules to seal that loophole.
That might explain why the IRS runs an initiative called the National Research Program, which chooses random returns to audit in order to identify what it gently refers to as “noncompliance.” There's an estimated $450 billion difference between what taxpayers owe and what they pay, and the NRP is, loosely speaking, one of three ways in which you can become an unwilling partner in the IRS’ efforts to close that tax gap. The second way to become a bogey lighting up the taxman’s radar screen is to make unforced errors on your return: bad math, getting your Social Security number wrong, not reporting income, etc. If any of these things describes you, I recommend hiring a more hands-on accountant. But when it comes to the third category, the one most likely to trip you up, I can help out.
Every red-blooded taxpaying American should know about IRS publication 556, which includes a brief mention of something called the Discriminant Inventory Function System. The DIF is a scoring system, and though the name is a mouthful, the agency’s explanation for why you should care about it is crystal clear: “If your return is selected because of a high score under the DIF system, the potential is high that an examination of your return will result in a change to your income tax liability.” And you can probably figure out which way that liability is most likely to change. So the DIF is more like golf than basketball: a low score is better. Though the exact methodology is a closely guarded secret, savvier accountants have come to learn which features of tax returns tend to act like pheromones for auditors. Here are five ways to avoid waving a red flag in front of the IRS when you file your 1040 next month.
No Good Deed
If you make $80,000 a year and give $10,000 to charity, you’re a good man. You’re also on your way to earning a pretty high DIF score. The IRS is thought to have thresholds above which deductions look suspicious, whether they're charitable deductions, business expenses, local taxes, or dentist bills. Janet Hagy, the Austin, Texas-based proprietor of accounting firm Hagy & Associates, says a client of hers is being audited because his charitable contributions look high relative to his income. Hagy says no one outside the IRS knows exactly what the level is that trips the alarm, but the IRS publishes a handy list of average itemized deductions. For taxpayers with adjusted gross income between $50,000 and $100,000 who itemized, the average charitable deduction was $2,815 in 2010 (the most recent data available). I’m not suggesting that you give less than that, but I'd recommend keeping impeccable records if you decide to give more.
Embrace the Decimals
Odds are the interest on your student loan isn’t exactly $500, so use the real number, not a rounded estimate, which can raise eyebrows at the IRS. “It might look like your record keeping is shoddy,” Hagy says. To make your, and your accountant’s, life far easier, buy a desk calendar and staple your receipts on the corresponding day, with a note explaining the expense. You’ll be bulletproof in an audit.
Don’t Drive and Deduct
The IRS allows you to write off 55.5 cents per mile (or to use a more complicated depreciation method) for business use of a personal car. But not so fast: Commuting doesn’t count. And you’ll need detailed records, such as “a daily log showing miles traveled, destination, and business purpose,” to quote the agency. Once again, don’t shy away from a valid deduction; just make sure that you're prepared to prove your case.
Know the Price You Paid
Since 2011 the IRS has required that brokers report investors’ “cost basis” on stocks, mutual funds, and other securities. If you sell something for more than you paid, that’s a taxable gain, and you owe taxes on the difference. (Losses are deductible.) If you sell an investment that you’ve owned since before 2011, Hagy suggests you tell the broker what you paid and ask that the cost basis be included on the 1099 form that lists your investment gains and losses. If it’s reported by the broker, she explains, it's less likely to be questioned by the taxman.
The Effects of Moonlighting
If you run your own business as a sole proprietor, do any freelance work (as your primary employment or just on the side), sell enough stuff on eBay, or even make a few bucks on a hobby, you need to file a Schedule C. On this form you’ll list all your expenses as well as your profits. The more expenses, the lower your reported profit, and therefore the lower your taxes. That incentive has proven a little too tempting for people like a hotdog vendor in Chicago who, according to a story on MarketWatch, reported that his “cost of goods sold” was 50% of his sales. That sounded a little steep to the IRS, and after an investigation revealed he hadn't reported all of his income, he paid a hefty fine and back taxes. If you need to file a Schedule C, assume your DIF score just went up.
Keep Your Cool
If, despite your best efforts to stay under the radar, you do hear from the IRS, don’t panic. Let your accountant handle everything—you're not required to meet with the IRS in person, and there’s little upside to doing so. If you’ve kept records and followed the rules, your accountant will be well armed. Hagy recalls an IRS agent who tried to force her client to attend the meeting. “I suspect the agent had just graduated from college within the past few months,” Hagy said. “She felt like she had a lot more power than she actually did.” In fact, the young auditor tried to bolster her demand by brandishing a law that actually required judicial intervention to force the taxpayer to attend a hearing. But no judge was involved. Not only did the client stay away, but “when the audit report finally came,” Hagy said, “the numbers were wrong. There were obvious mathematical errors.” The total tax owed? Not a dime.