The lion share of IRS audits last year — 1.2 million — were done by mail. Only 392,000 involved an in-person meeting with the IRS. That’s not necessarily good news.
Taxpayers overall face a low audit risk: The IRS audited 1.1% of all individual tax returns filed in 2010, or 1.6 million returns of 141 million filed.
Taxpayers often are confused by IRS correspondence and with such audits don’t have the benefit of working with one single agent, the National Taxpayer Advocate says.
But the risk of an audit skyrockets for some. Fully 12.5% of taxpayers whose income topped $1 million faced an audit. And self-employed people who filed a Schedule C with gross receipts of $100,000 or more faced an audit rate of about 4% — four times higher than average taxpayers.
Here are seven red flags to watch out for, from Andrea Coombes at MarketWatch:
1. Schedule C
Sole proprietors filing a Schedule C can reduce their audit risk by sticking to the facts — or at least making sure their expenses and income are not dramatically different from similar businesses.
For example, one Chicago-based hot-dog-stand owner said his cost of goods sold was 50% of gross receipts, said Robert McKenzie, a partner in the law firm Arnstein & Lehr. “I know Chicago hot dogs are great, but he had a high cost.”
The IRS found the hot-dog salesman was reporting his expenses but only part of his revenue. He faced “a lot of tax and penalty,” McKenzie said.
Check out BizStats.com for an idea of whether your numbers are out of line; McKenzie said the IRS tells its agents to review that site for average business costs.
2. Rental losses
If you show income from your job or business and claim rental-property losses, be wary. The IRS rules limit deducting those losses in the current year, unless you prove you’re actively involved in managing the property.
“It’s a real hot item right now: Audit people who make significant income from their jobs and also claim rental losses,” McKenzie said.
In one case, the wife of a real-estate attorney — a stay-at-home mom with three young kids — managed the family’s rental properties, but the IRS said the couple couldn’t deduct rental losses in the current year. On appeal they won their case, McKenzie said.
“We were able to prove yes, he couldn’t have devoted 50% of his time [to the rentals] and made $600,000 a year, but she could,” he said.
[Related: Money Mistakes That Nearly Everyone Makes]
3. Over-the-top deductions
Taxpayers who claim large deductions attract attention. “Anything that is significantly above what persons in your income bracket might deduct is likely to be looked at,” McKenzie said.
For example, claiming $30,000 in mortgage interest on a $60,000 salary. “Is it because I’ve had a bad year in income, or is it because I really manage my money well and I live modestly except for my very nice house, or could it be I’m earning more money than I’m reporting?” he said.
Got records to back up your claim? By all means take the deduction. “The mantra I preach to my clients is keep good records,” said Audrey L. Griffin, an enrolled agent in Centerville, Ga. “You’re going to get the best possible, honest, legal result and you have nothing to fear.”
CCH Inc., a Wolters Kluwer business, publishes average amounts for some popular deductions. See the CCH page.
4. Business or hobby?
The IRS may decide your business is a hobby — especially if you have other income sources. For example, McKenzie said, the IRS disagreed with an executive who, in addition to his annual salary of $500,000, deducted expenses for his yacht, claiming it was a business charter operation.
In another case, a young man with annual trust-fund income of $300,000 decided to become a race-car driver. He wrote off his costs, including the car, maintenance and the like.
In both cases, the taxpayers settled with the IRS for a partial write-off, McKenzie said. “The bottom line is, the IRS originally challenged these guys making a lot of money but also showing losses on Schedule Cs.”
[Related: Use Your Tax Refund Wisely]
5. Business use of a car
Griffin’s clients often insist that 100% of their driving is related to business and thus their costs are 100% deductible, but when she digs deeper she finds they often use that same car for nonbusiness purposes.
“Then it’s not 100%, which is the reason the IRS requires you to keep mileage records — date of trip, purpose of trip and the mileage,” she said.
You can choose to use the IRS’s standard mileage rate or track your own, but either way, keep a mileage log and record your expenses, she said.
6. Home-office deduction
You may be able to claim a deduction for expenses related to your home office, including home-insurance and utilities costs, but be prepared for the IRS’s attention.
“I would not discourage a client from taking that deduction if they qualify. I just try very hard to make sure they know the requirements and keep good records,” Griffin said.
Claiming a section of a room is possible — say a corner of the guest room that’s dedicated office space. If “nobody does anything personal in that corner, then that little bit would qualify,” Griffin said.
But is it worth it? You would claim a deduction for a percentage of the housing expense related to the square feet of office space divided by the home’s total square footage.
“It may be a very small percentage and it may not be worth raising this red flag,” Griffin said.
7. Earned-income tax credit
Among people who claimed the EITC — a refundable credit worth up to $5,751 in 2011 for moderate-income taxpayers — 2.2% of returns filed in 2010 were audited.
There’s a “high level of noncompliance,” McKenzie said, often because fraudsters exploit this benefit to line their own pockets.
For instance, scammers will provide an extra Social Security number so taxpayers can claim an extra dependent — and increase their credit.
It’s a valid tax credit — just mind the scams and stick to the truth.