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Avoid That Audit

Jennifer Openshaw

Avoid tax shelters. Make sure your side business earns money, at least once in a while. Make sure its deductions and the home office are legit. Don't refile your return.

But you know what? Even without a side business or any special deductions, you still might be in the IRS cross hairs. Now, full disclosure: I strongly support paying the taxes you're legally required to pay. But no more. And if you're paying what you should be, and can explain it, an audit shouldn't be a problem.

But why take the chance? Good tax planning means paying as little as possible -- and not waking the sleeping tiger.

First, let me share a little insight into how the IRS does business.

The IRS uses a complex mathematical model known as the DIF, or Discriminate Index Function system. (I know, how'd you like to meet the folks who came up with that name?) Some call it the "audit lottery," but it's really more than that. It's not chance but rather a data-mining tool that creates a three-digit score much like a credit score. Only in this case, you want your score to be low.

The IRS doesn't release much about the formula -- it's guarded better than the recipe for Coke. Most IRS agents and employees have no idea how it works.

Here's what I can tell you: DIF uses your deductions to assign a score that considers your potential income and wealth, your occupation, your zip code, your tax history and what's "normal" for others like you.

Click here for the video version of this story from Jennifer Openshaw.

So listen up: The secret to not being DIF'd is to not stick out, in any one area or across the combined return. Here's my advice.

• Report all your income. In 2002, the IRS added a new module to DIF to target underreported income. The IRS looks at what you and others like you earned, doing what you do and where you do it. If it believes you could have reported more, your score goes up.
• Check your big-picture deductions. Your total of Schedule A deductions should be less than 45% of adjusted gross income, or AGI. If higher, it sends a signal to the IRS that you either have too many deductions or have reported too little income. Stated differently, the IRS would like to know how you can live on 55% of your income. Similarly, Schedule C deductions should stay under 60% of AGI.
• Keep your line-item deductions in check. The DIF formula reviews Schedule A line items against income, who you are and where you live. Because I don't know the formula, I can't give specific guidelines. The IRS does publish the average amount taken for deductions by income group. So I went and found the following at the IRS Web site.

  From my research, for example, the average earner bringing in $150,000 a year has $3,411 in cash charitable contributions and $1,177 in noncash deductions. It's OK to donate more, but if you're donating three times that much, look out.

  Again, try not to stand out. Remember, DIF considers where you live, so it knows mortgage interest and taxes are higher in expensive big cities or coastal states. I'll leave the rest to you and your tax adviser.

• Be precise. Believe it or not, using too many round figures can make your return look suspicious. Reporting a total of $1,591 for charitable contributions looks better than reporting $1,500 -- it looks more like a real tabulation and less like a rough guess.

I realize there isn't much you can do about some of these DIF triggers. But it still helps to know when an audit might be coming and to be prepared.

Either way, just like with credit scores, be smart and do what you can to eliminate the bad.