The IRS audits more than a million Americans each year — and you can avoid becoming one of them.
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For example, certain deductions automatically throw up red flags and invite an audit: the home-office deduction, business losses, charitable contributions, and excessive deductions.
Experts recommend several different strategies to avoid audits, but they all boil down to this: don't try claiming deductions and credits to which you aren't entitled, keep thorough and accurate records during the year, and follow Internal Revenue Service instructions carefully.
"The best defense is a good offense," says Maggie Doedtman, manager of tax advice delivery for H&R Block at its Kansas City, Mo., headquarters. "You don't have to worry about an audit as long as you prepare honestly and have the receipts to prove it."
A few tricks of the trade on how to keep a low profile with the IRS:
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Home office: People who are self-employed or run a business from home are entitled to write off the expenses of maintaining an office at home. You can make deductions for your computer, office furniture, a portion of your rent if you live in an apartment, part of your utilities, and some insurance and repair costs.
But be careful — you can't use your office space for any other purposes. "You can't sit on your lounge chair to work on your computer," says Saul Brenner, a tax partner at Berdon LLP in New York City. "You have to have your office set aside."
If you are operating a business from home in addition to a full-time job, the IRS is particularly likely to raise its eyebrows if you claim the home-office deduction.
But don't freak out if you really do have a business at home. "With the advent of the Internet, we're seeing a lot more of it," Doedtman says. "My philosophy is that if you're entitled to it, you should claim it. Just make sure you use it regularly and exclusively for business. Have a separate computer for your kids' video games."
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Business losses: If you have a legitimate business at home and it loses money, you can write off the losses. But to be considered a legitimate business, it has to have been profitable in three of the past five years. Otherwise it's just a hobby in the IRS' eyes.
"If you say you're raising horses as a business, and your kids are riding them and your cousins are coming to ride them, and you're just going to your farm for weekends," you could be in trouble, Brenner says.
So if you're just looking for an easy tax break, take heed. And of course make sure you have good records. Doedtman points out that for Internet businesses, you'll generally have records kept for you on the Web. "People doing online sales through eBay, for example, can use PayPal to keep their records," she says.
Charitable contributions: If you're declaring a donation of $250 or more, a canceled check isn't good enough. You need written acknowledgement of your donation from the charity. For a noncash contribution over $5,000, you need a certified appraisal.
"It can't be your next-door neighbor or your brother-in-law," says Richard Rampell, head of the Rampell & Rampell accounting firm in Palm Beach, Fla.
Starting next year, a written acknowledgement of cash donations will be necessary for any amount given. "Congress and the IRS realize that things aren't totally according to Hoyle," Brenner says. "They have seen people get very aggressive in their deductions."
For example, it has become popular for people to give away an old car to charity and declare its value as if it was a brand-new Mercedes. "People were giving away cars to charitable organizations at values that were, shall we say, aggressive," Brenner says.
Excessive deductions: Take what you're entitled to, but don't overdo it. The IRS has calculated what it considers to be the normal range of deductions for each level of income, and if you exceed that range, your return could get flagged for an audit. Among the expenses you can take as itemized deductions are interest payments, state and local income taxes, contributions, and medical expenses that exceed 7.5 percent of your income.
The IRS doesn't reveal what its ranges are for itemized deductions, but here are the average total deductions for taxpayers (figure are from taxes filed for 2004, the latest data available):
For those with adjusted gross income of $30,000-$50,000, itemized deductions averaged $13,983.
For those in the $50,000-$100,000 bracket, it was $17,999.
For those earning $100,000-$200,000, itemized deductions averaged $26,194.
And for those with adjusted gross income of $200,000 or more, it was $66,950.
The IRS also puts out a list of what it calls "Dirty Dozen" tax scams. Falling for them could mean a lot worse punishment for you than just an audit. "You don't want to get caught doing any of these things," says Jeff Azis, an accountant in North Palm Beach, Fla. "You could be looking at a hefty fine, or even prison."
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Tops on the IRS list is abuse of the telephone excise tax refund. This tax was placed on phone usage in 1898. It was a luxury tax, because in those days, and for many years afterward, using the phone was indeed a luxury. "It stayed in place until just a year ago, but then it was declared illegal," Rampell says.
So now you can take a credit for the tax — a credit that's generally $30 to $60. But some people are claiming much more. They are trying to get refunds for the entire amount of their phone bills, rather than the 3 percent tax on long-distance and bundled services that is eligible to be refunded. Abusing this credit is a pretty good invitation for an audit.
Some advisers also are pushing illegal Roth IRA deductions. One example of this scheme is putting under-valued common stock into a Roth IRA, which would theoretically let you avoid the maximum annual contribution limit for Roth IRAs and make otherwise taxable income untaxed. Don't fall for it.
Trust abuse is another problem. Some trust operators urge taxpayers to put their money in them, promising that income will be tax-free, personal expenses can be deducted as part of the trust, and estate and gift taxes will be reduced. This is true for legitimate trusts, but many of these trusts are shady. So be on guard.
Some people have come up with a few ideas that are really way out there as an excuse for not paying taxes, and these almost guarantee an audit or worse. One argument is that the 16th Amendment giving Congress the right to impose taxes was never ratified; another is that wages aren't income; and yet another is that tax payments are voluntary. It's a bad idea to act on any of these fanciful notions.
Experts say a few other things can trip up taxpayers. For the earned-income tax credit available to people of modest income and a family to support, some taxpayers have claimed nonexistent children, or sometimes even pets, as dependents, Rampell says.
Now, the IRS traces Social Security numbers of all dependents who are claimed on their parents' returns for the benefit of the credit. So if you're claiming your child as a dependent, make sure the child has a Social Security number.
And in general, double-check all your math work and the entries you put on each line. It's very easy to make a simple math mistake or to put the correct number on the incorrect line.
In the end, a little common sense goes a long way. "The only way to guarantee you won't get audited is not to take advantage of any deductions, credits, and so on. But of course, that's the worst tax advice you can give anybody," Doedtman says.
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