An audit from the IRS is not only stressful, but also time-consuming, especially if your record-keeping is not up to par.
Exercising restraint in writing off expenses and deductions and losses for 2019 can help you avoid the wrath of Uncle Sam.
Seeking the help of a tax professional can lower your taxable income legally.
Here are the top 14 tips to avoid the extra glance from an IRS auditor.
How to Avoid a Tax Audit: 14 Ways
1. Report All of Your Income
Taxpayers need to report all income, even if there is no W-2 or 1099 for that income, including any stocks, trades or cryptocurrency transactions, said Mark Steber, chief tax officer at Jackson Hewitt Tax Service, a Parsippany, N.J.-based tax prep company.
“Audits are very real and something taxpayers shouldn’t take lightly,” he said. “My best advice is to use a tax pro to help prevent mistakes and get help should an audit occur. For business owners, the IRS will expect a business plan if audited and businesses are allowed a net loss for any two out of five consecutive years, if there are any more, it is a red flag. If audited, the IRS is likely to view the business as a not-for-profit hobby that would not allow tax deductions.”
2. Choose Mark-to-Market if You're a Trader
The best way to make sure you prove your active trader status is to attach footnote documentation with your tax return clearly laying out how you qualified for trader status against IRS Tax Topic 429, said Brian Rivera, a CPA based in Orlando. Active day traders can potentially elect section 475 mark-to-market and deduct all reasonable business expenses.
“In the event your return is selected for an audit, your clear and concise easy to follow footnotes can assist the IRS in the examination of your return,” he said. “Filing day trader tax returns can be extremely complicated. The IRS guidance on what is considered an active day trader is not clearly defined.”
3. Invest in Assets that Produce Passive Income
Taxpayers who are not residing in the U.S. but still have American-sourced income should structure their investments “so that their individual identity is never revealed,” said Patrick McCormick, a partner in the Philadelphia offices of Culhane Meadow whose practice focuses on international taxation for high net-worth individuals and corporations.
“Non-residents can do this by investing only in assets which produce passive income, which under normal circumstances, means they don’t need to file a U.S. tax return,” he said. “Those with income tax filing requirements can avoid disclosure by incorporating their U.S. interests, which also protects them from future transfer tax exposure.”
U.S. taxpayers holding interests in foreign corporations controlled by American taxpayers are subject to onerous tax requirements. Failure to file information returns exposes an individual to $10,000 in annual penalties, and the statute of limitations for their income tax return remains open until the information form is filed, McCormick said.
“Given the complexity of reporting here, the IRS does offer options to retroactively cure prior failures with little or no penalty – being proactive about curing prior failures is critical to minimize ramifications,” McCormick said.
4. Only Itemize Deductions if You Have the Paperwork
Only claim itemized deductions that are provable and ensure that you have the proper documentation to back any deductions you are claiming, said Jeff Warnkin, a CPA at the JL Smith Group, an Avon, Ohio-based financial planning firm.
“If you find yourself itemizing by a significant amount when compared to the previous year, provide an explanation with your return about the variance,” he said.
5. Avoid Consecutive Years of Losses
If you file as a business, “you actually need to make money some years,” Warnkin said.
“If you file returns that report a business loss year after year, with no other sources of income, you may draw the attention of the IRS,” he said.
6. Don’t Forget About Savings Accounts
Make sure you include everything that gets reported directly to IRS because that 1099-INT for $25 in interest that shows up in the mail after you already dropped off your taxes can be an issue.
“The IRS matching program will generate a notice and bill you for the difference,” Warnkin said. “Keep a record of what documents you should be expecting for the year. Look at last year’s return and make sure you have everything that was previously listed.”
7. Examine Your Charitable Donations
People who donate a significant amount of their yearly income could raise red flags, Warnkin said.
“Make sure you obtain a written acknowledgement from the charity for donations over $250,” he said.
8. Incorporate Your Schedule C
The Schedule C is the tax form filed by most sole proprietors.
The IRS will look at your Schedule C business more closely than an LLC, Warnkin said.
9. Watch Your Alimony Payments
Make sure you and your ex-spouse are on the same page on how to claim the alimony, he said.
If you both file with different numbers, then you both may be hearing from the IRS. Keep accurate records of alimony paid and received
10. Keep Records for Claiming the Earned Income Credit (EIC)
Taxpayers who claim the earned income credit, a benefit for working people with low to moderate income, still must file a tax return, “even if you do not owe any tax or are not required to file,” according to the IRS.
“EITC reduces the amount of tax you owe and may give you a refund,” the website said.
Individuals who claim the EIC have a higher chance of being audited because of the refund it entitles people to, Warnkin said.
“Make sure you complete and retain your due diligence records that prove you are entitled to the credit,” he said.
11. Double Check Your Return
Errors can lead you to an audit situation, said Brian Hogan, an assistant professor of business administration of the University of Pittsburgh Katz Graduate School of Business.
12. Keep Up With Tax Law Changes
Using good tax preparation software can alleviate this concern, Hogan said.
13. Keep Your Expenses Consistent
The IRS expects expenses to be consistent and approximately represent the same percentage of revenue from year-to-year, said Daniel Laginess, a CPA and managing partner at Creative Financial Solutions in Southfield, Michigan.
“The IRS also scrutinizes returns more often that take deductions for home office expenses,” he said. “Self-employed taxpayers present a higher risk to the IRS because there is much more opportunity for deductions and unreported income.”
14. Avoid Crossing the Line
The IRS reports that it audits taxpayers in high tax brackets and those that report little to no income more often, especially taxpayers that are in a cash business, Laginess said.
“Please be smart, find a good tax adviser, take advantage of all the opportunities to reduce your taxes and receive tax credits that are legal and within the tax code,” he said. “Don’t cross the line and you should have nothing to worry about.”