How to survive a tax audit


Although the IRS audits less than 1% of all tax returns, it still happens. Few experiences are more terrifying than receiving an audit notice from the IRS. If you're one of the unfortunate taxpayers in this particular situation, don't panic. An audit is not the end of the world, and it doesn't necessarily mean that you'll end up owing tons of extra taxes, either.

If you know how to play the audit game, you can minimize your risk of getting slapped with extra tax charges. In rare cases, audit victims have even won refunds as a result of their audits.

Find your audit trigger

If you're being audited, it's because the auditor found something that looks suspicious in your tax return. If you can figure out what that suspicious item was before the audit starts, you'll have a better chance to prepare a strong defense.

With correspondence audits, which are conducted entirely by mail and make up around 80% of all audits, you'll know what the problem was because the letter will ask for information to back up that item. With office or field audits, however, you won't find out what the problem item or items are until the audit begins.

For these audits, consider taking your tax return to a tax professional for advice, as he or she will likely be able to spot the issue quickly. Common audit triggers include deductions that were greater than 50% of your income for the year, claiming the Earned Income Credit, not reporting income, claiming lots of entertainment deductions and/or vehicle deductions, and having basic errors on your return (e.g. getting your own Social Security number wrong).

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Common tax missteps that will get you audited
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Common tax missteps that will get you audited

1. Hiring the wrong tax preparer

This mistake might occur before you even get your name on the tax return. Select a tax preparer who is incompetent or unethical, and he or she could spell big trouble for you.

If the IRS audits one of the returns the tax preparer filed and finds significant problems, the agency could decide to audit all the returns that person prepared for the year, or for the past several years.

Don’t make this mistake. Read our advice on how to select the best tax pro.

2. Saying your hobby is a business

Let’s say you breed and sell dogs, or sell blankets on Etsy, or resell garage sale purchases on eBay. At the end of the year, you realize expenses exceeded what you made and decide to deduct a tax loss from your “business.”

However, if you do that for three or more years, the IRS is going to get suspicious. A business is something that makes money. If you haven’t made money in three years, what you have may actually be a hobby.

The IRS doesn’t allow business deductions for hobbies.

3. Filing certain schedules or forms

You might say the third item on our list isn’t a mistake because, in many cases, there is no way to avoid it. For example, if you have a business, you need to file a Schedule C. And yet filing a Schedule C increases your chances of an audit.

However, it would be a mistake to file a Schedule C if you have an unprofitable business that is more like a hobby. It might also be a mistake to file a Form 5213 if you’re not sure.

Form 5213 prevents the IRS from auditing you for the first five years of your business, and it is typically used when transitioning a hobby into a business.

This form allows you to claim losses from your hobby-turned-business, no questions asked. That is, until the five years are up, and the IRS comes calling to see what you’ve been up to.

4. Taking questionable deductions or credits

Experts generally agree that claiming excessive charitable contributions and claiming a home office are the two deductions most likely to raise red flags with the IRS.

If you donate a large percentage of your income to charity, be sure to keep careful records. Too many contributions, relative to your income, can be a problem. So think twice about inflating the value of those items you dropped off at the thrift store.

Keep careful records of all donations and be sure to get a written acknowledgement from any charity to which you donate $250 or more per year.

As for the home office, take the deduction to which you’re entitled — here’s a piece that explains how it works — but be ready to defend it if needed. The most important thing to remember is you can only deduct a home office if you use that space exclusively for business.

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Under the category of credits, the Earned Income Tax Credit is most likely to get you in trouble, according to experts.

Back in 2013, the IRS came under fire for not taking enough action to curtail improperly awarded Earned Income Tax Credits. In a statement reported by multiple news outlets, the agency fired back by saying EITC claims were twice as likely to be audited as other returns. If you claim the EITC, consider yourself warned.

For more on the subject, check out: “Don’t Miss These 16 Often-Overlooked Tax Breaks.”

5. Claiming a loss from a rental

When housing prices were depressed, some people converted homes into rentals rather than selling them. Those who found the rent didn’t cover the mortgage and taxes may have assumed they were entitled to take a deduction for the losses.

Not so fast. You have to either be an active participant in the management of your rental or a real estate professional to do that. The IRS has a long and confusing page with the details, but Nolo.com has a much clearer explanation.

Make sure you’re eligible to deduct the losses before doing so.

Also read: “10 Keys to Finding and Owning the Perfect Rental Property.”

6. Failing to claim all of your income

Thinking you can keep secrets from the IRS is a mistake.

You may think the government won’t know about the money you earned freelancing on the side, but if the company you worked for files a 1099 form, the IRS knows.

You may think you can keep your alimony checks a secret, but if your spouse is reporting those payments on his or her return, the IRS knows.

You may think the interest you earn from foreign bank accounts is between you and that country’s bankers, but if those nice bankers are sharing information with the United States, the IRS knows.

Don’t take the chance of getting caught in a lie. Claim all your income. Then, the IRS won’t have any discrepancies to note, giving it one less reason to flag your return for an audit.

7. Making math errors

The last mistake on our list is also the simplest mistake to avoid: math errors.

If you can’t add and subtract correctly, the IRS might start wondering what else you got wrong in preparing your return. Avoid this audit trigger by using tax software or an online program that will virtually ensure the calculations are correct. If you earn less than $64,000, you can find free online tax prep through the IRS Free File program.

What’s your experience with the IRS? Share in our comments section below or on our Facebook page.

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Back up your claims

Having documentation to prove that you really did qualify for all those deductions is worth its weight in gold during an audit. However, not every taxpayer is able or willing to hang on to all those bits of paper for three to six years.

If you're missing specific documents, such as receipts or mileage logs, you may be able to create a reconstruction that will stand up to an auditor's scrutiny. For example, if you didn't keep a mileage log and the auditor is questioning your auto deduction, pull out your daily planner for the year and use it to create a mileage log after the fact. If you don't have a daily planner, you may be able to use emails, letters, or invoices to figure out which days you met with clients, or otherwise used your car for business purposes. When you give the newly created mileage log to the auditor, explain that it's a reconstruction based on your scheduling information from that year.

Be polite, but not helpful

Audits make people very nervous, and nervous people tend to talk more. Auditors are trained to take advantage of this aspect of human nature, and they will often try to get you to spill your guts with tactics like sitting silently for long periods of time or asking leading questions. They're hoping that you will blurt out some detail that will give them a lead on something they should be investigating. Don't say something just to fill the silence; wait until the auditor asks a question, and then reply briefly and to the point. If you don't know the answer, say so and ask for more time to check your records or consult with your tax preparer. However, never tell a lie, no matter what the auditor asks. Lying to an IRS employee is a felony.

Negotiate

Let's say your auditor decides to disallow some of those deductions you claimed, and slaps you with an additional $5,000 tax bill. You don't have to just sit there and take it -- consider negotiating for a reduced bill. If you stand up for yourself and suggest a compromise, such as only disallowing half the deductions and letting you claim the other half, auditors will often either accept your compromise or make a counter-compromise.

If you can't get the auditor to agree to an acceptable deal, say something like, "I really don't want to go through the hassle of an appeal if I don't have to. Can you reconsider?" The warning that you're willing to file an appeal can be enough to convince the auditor that they should really give you something now instead of potentially having an appeals officer overrule them entirely.

When all else fails, appeal

If you've tried negotiating and you just can't get the results you want, file an appeal. You've got nothing to lose. The appeals process is fairly painless and costs nothing -- unless you decide to hire a tax professional to represent you. And unless a great deal of money is on the line, that's usually not necessary.

If your proposed tax bill is $25,000 or less, you can file an appeal under the Small Case Request procedure, which simply requires you to fill out Form 12203 and send it in. If you owe more than that, you'll need to write a formal letter and send it to the Office of Appeals.

Remember your rights

Most auditors are quite reasonable and professional during audits. If you're unfortunate enough to have an auditor who is abusive or overly hostile, politely ask them to stop. The Taxpayer Bill of Rights gives every taxpayer "the right to receive prompt, courteous, and professional assistance in their dealings with the IRS," and you don't need to put up with behavior that violates those standards. If confronting the auditor doesn't help, ask for the name of their manager and call to make a complaint. The manager may or may not assign you a different auditor, but this should be enough to get your auditor to treat you more respectfully.

Similarly, you should be polite and respectful to the auditor, not abusive. Remember, the auditor is just doing a job. Treat the auditor the way you would want to be treated by your own customers.

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