Not only is an audit unlikely to happen – if it does, it’s rarely a huge deal
Few words inspire such fear in the hearts of Americans as “IRS audit.” In fact, 27 percent of Americans said they rather get an “IRS” tattoo than deal with the agency ever again, writes Money magazine. But one of the biggest mistakes that taxpayers make is letting fear of the Internal Revenue Service stop them from taking advantage of tax savings they deserve.
A tax audit might be a nuisance, but it’s usually not more than that – and chances are extremely high that it will never happen at all. That doesn’t mean it’s open season to cheat on your taxes; you should always be methodically honest. But since audit rates are historically low, many experts agree that it pays to be aggressive because most legitimate deductions are unlikely to raise red flags.
In other words, while it’s wise to respect the IRS, there is less reason to fear it.
Fear of IRS audits – which the IRS actually calls “examinations” – are fueled by speculation that the IRS feeds into by being evasive about its audit process. Read on for a few facts about tax audits that may help ease your fears.
- You have a better chance of living to 100 than getting audited by the IRS. The average American faces a less than 1 percent chance – one in 160, to be exact – of experiencing an IRS audit. And those low odds may sink even lower, thanks to continuous budget cuts at the IRS that result in less personnel to perform audits. Only 0.6 percent of taxpayers were audited in 2017 – the lowest number in 15 years.
- A tax audit doesn’t always mean you’re in trouble. While the IRS does audit people it suspects have done something wrong, your selection for an audit can also purely be a matter of chance. In fact, of the 1.1 million tax returns audited in 2017, about 34,000 actually resulted in refunds to the taxpayer.
- You can lower your chances of an audit. A computerized scoring system called the Discriminant Index Function (DIF) helps the IRS choose which tax returns to audit. This system assigns a score to individual and corporate tax returns, and scoring above the national average ups your chances of triggering unwanted attention from the IRS.
Tax returns flagged by the DIF system are manually screened to determine if there is a cause for audit. Items that might increase your score include:
- Income other than basic wages, such as contract payments.
- Unreported income, such as investments.
- Owning a small business – especially if it’s a sole proprietorship or in a cash industry like coin-operated laundromats, where it’s easier to hide income and skim profits.
- Reporting losses from businesses that the IRS classifies as hobbies. For instance, if you train dogs and take a loss every year, the IRS may take a closer a look to determine if your business is really a hobby and doesn’t qualify for deductions.
- Deductions and credits for unusual amounts. If you claim that you give a significant chunk of your income to charity as non-cash contributions, the IRS may pay attention. Another red flag is excessive home office deductions.
- The new tax code made significant changes to the deductibility of business meals and entertainment starting this year, and it’s expected to be highly scrutinized by the IRS during tax season. In broad strokes, entertainment expenses are no longer deductible and most meals are now only 50 percent deductible – and only then if business is discussed.
- You can only deduct losses not reimbursed by your insurance company. If you write off a large casualty loss, the IRS may take a closer look at the situation.
- That said, go ahead and take a reasonable home office deduction. Too many people avoid taking certain credits and deductions – denying themselves savings to which they are legally entitled – because they’ve heard that taking them makes them more susceptible to an audit. Home office deductions are often the epicenter of audit fears, as the IRS has been known to scrutinize returns that include them to make sure taxpayers aren’t simply writing off personal expenses.
But here’s the thing: it’s always OK to claim legitimate expenses, no matter how long your list gets. It’s true that the IRS has established ranges for amounts of itemized deductions based on your income. The scanning system may flag deductions that exceed the statistical norm for your region and state – or just seem unlikely, such as charitable contributions that exceed your income.
But that doesn’t mean you shouldn’t take all the deductions you deserve. If you have valid backup documentation that you’re telling the truth, you have nothing to fear from the IRS – even in the unlikely event that you get the dreaded audit letter.
- An audit is no reason for panic. Many times, an IRS audit isn’t what you expect – the IRS simply wants additional documentation or a response about a particular item. But even if you lose after a full-blown audit, you may only receive a “deficiency notice” – a simple bill for more tax.
The IRS can impose an accuracy-related penalty equal to 20 percent of any underpayment of federal tax that results from many types of misconduct, including disregard of rules and negligence. But even then, you may be able to avoid the penalty if you can show a “reasonable basis” for the position you took on your return.
It’s a crime to cheat on your taxes – it’s impossible to overstate the difference between legal tax avoidance and illegal tax evasion. But honest mistakes or even negligence aren’t likely to trigger a criminal investigation – meaning the average American shouldn’t worry about being charged with criminal tax fraud or evasion.
At the end of the day, the average American has little to fear from the IRS – and should never be afraid of taking a legitimate deduction. Refusing to claim money that’s rightfully yours is the same as simply gifting your hard-earned cash to the government.
An experienced certified public accountant will work diligently to help you uncover all the different tax savings you deserve. And if a CPA does recommend that you steer clear of a strategy that you think is valid, be sure to investigate further before giving into a vague threat that it will raise a red flag. While you can never guarantee that the IRS won’t audit your return, in today’s tax climate, the odds are ever in your favor.
Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on tax planning, and to find out how we can help your business exceed your expectations.