Top Five Ways to Avoid a Tax Audit

While audits are rare, most Americans would probably like to avoid them altogether. The percentage of people who actually are audited is extremely small, according to the Internal Revenue Service, but the number has risen slowly since 2008. If the IRS does decide to audit you, there is little you may do to stop it. You may, however, reduce the odds that you will be singled out for that extra attention in the first place.

“The largest pool of filers – which consists of individuals or joint filers who earned less than $200,000 but more than the lowest earners – tends to avoid overt scrutiny,” said Thomas Jensen, managing partner at Vaerdi Financial.

One of the most common red flags for auditors – erroneous data entry – is also one of the most preventable. It seems simple enough to follow the advice to “double-check your return,” but surprisingly, people often are too careless regarding their taxes, said Thomas Jensen, managing partner of Vaerdi Financial in Portland, Oregon.

He advised waiting for all your income reports, bank and investment statements and other applicable financial paperwork to arrive before starting your tax return.

“Sometimes people simply forget (income) or they don’t get all of their forms gathered, and they make mistakes that are avoidable,” Jensen said.

Correctly reporting dependents and exemptions, as well as ensuring that the numbers match, is important because the IRS's automated system will easily detect discrepancies, Jensen said. "And they don’t know if that is a mistake or purposeful.”

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Perhaps it’s common sense, but being 100 percent truthful on your tax return is an absolute must to reduce the chances of an audit. Realistically reporting income, deductions, credits and other figures can help keep the tax man at bay, Jensen said.

Not reporting all your income is a surefire way to attract attention, said Tim Clegg, a Boston-based financial coach and retired tax advocate.

“Outright lying, especially if you earn a six-figure income or are hiding large sums of cash, is definitely a behavior that will get you audited,” Clegg said. You should be prepared to look an auditor in the eye and support any number you claimed on your return, Clegg says. Self-employed filers, for example, should have receipts for every business deduction they claim.

The largest pool of filers – which consists of individuals or joint filers who earned less than $200,000 but more than the lowest earners – tends to avoid overt scrutiny, Jensen said. Taxpayers who make more than $1 million a year and those in very low income brackets are most likely to be audited.

“The wealthy take more deductions, contribute to more charities and other things so they have a higher risk of getting audited,” Jensen said. “Also, any filer who files a Schedule C is about four times more likely to receive questions.”

Those in what the IRS determines to be the low income bracket (a married couple with three children earning $50,270 or less in 2011) have access to the Earned Income Tax Credit.

Both categories historically are fertile grounds for fraud and – because of the greater complexity – mistakes in data entry. If you file Form 1040-EZ, pay rent, don’t have children and make a modest income, there is virtually no chance you will be audited “unless you make some sort of mistake with your numbers” or unless your “costs are out of the norm,” Jensen said.

“For example, giving away more than 30 percent of your income to charity is something most people don’t do,” he said. “That could draw attention.”

Unusual or unrealistic itemized deductions, either for individuals or small business owners, may raise a red flag for auditors.

For a sole proprietor who files Schedule C, which details profits and business expenses, reporting losses for three years or more could encourage an auditor to request proof that the filer is actually in business, Jensen said.

Filers itemizing deductions on Schedule A must know what constitutes a legitimate deduction, said Sandy Zinman, founder of Zinman Accounting and chairman of the tax committee for the National Conference of CPA Practitioners. Daily commuting to your regular job, for example, is not a legitimate deduction, he said, but a special trip to woo a client is.

"There are a lot of assumptions out there about what should be deductible or not," said Zinman. "An IRS examiner once said to me, 'Anything you have to spend money on to make money on is deductible.' I think that is a pretty safe rule."

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The Internal Revenue Service maintains that filing returns electronically can “dramatically reduce errors,” lowering the odds of an audit.

On Jan. 24, 1986, the IRS received its first electronically filed tax return from a preparer. By 1989, taxpayers in 36 states could file their federal taxes electronically. By 1990, taxpayers throughout the country who expected a refund could file electronically. Out of nearly 143 million individual tax returns received by the IRS in 2010, 98.7 million were e-filed.

The error rate for a paper return, the IRS reported, is 21 percent. The rate for returns filed electronically is 0.5 percent.

The word “audit” fosters trepidation in many people, but in reality the deep-tissue audits people tend to envision are fairly rare.

In the most common federal audits, taxpayers receive notices from the IRS asking about certain details of their returns and requesting further information or clarification. This is known as a “correspondence audit.” Even those are rare, Zinman said.

“The probability of being audited is so limited, so minuscule compared to, say, the probability of getting struck by lightning,” Zinman said, chuckling.

According to the IRS, of the nearly 141 million individual returns filed for fiscal year 2011, 1.1 percent were audited.

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