The process by which the IRS determines which returns to audit is not revealed, but tax professionals are able to determine common triggers and red flags. If something on your return is questioned by the IRS it doesn't necessarily mean that it's wrong, but you need to be fully prepared to defend yourself if you are audited.
Common audit triggers include:
High Income: It's true, higher income earners are audited more often. In 2008, taxpayers earning less than $200,000 were audited .95% of the time, while those earning more than $1 million were audited at a rate of 5.57%. As long as your documentation is in place you should be fine.
Large Charitable Donations: Making a large charitable contribution is another audit trigger, especially if the donation is large in comparison to your income. It is very important to have cancelled checks, receipts, statements and acknowledgements from the charitable organization to defend your deductions.
Foreign Bank Accounts: Off-shore accounts are on the top of the government's list of red-flag items. If you have an offshore account, be sure to report it and any interest earned in that account. Also, you must report foreign bank deposits that exceed $10,000 at any point during the year on Form 90-22.1.
Cost Basis on Stock Sales: If you sold stocks this year, you must go back and find the exact price of the stock when you purchased it so that the IRS can determine how much profit you made on the stock sale. In the future, investment companies are required to disclose your cost basis of investment purchases.
Home-office and Self-Employed Deductions: With more Americans losing their jobs, more taxpayers will be trying to claim home-office and self-employed deductions. The IRS has become increasingly skeptical of the legitimacy of home-based and cash-based businesses, which could make audits in this category more likely. To show that your home-business is legitimate, you must keep detailed and accurate records of business income and expenses and you should keep separate business and personal bank accounts.
Mismatched income: IRS audit letters are most commonly generated when the IRS receives reporting that does not match the amount claimed on your tax return. Common examples are employer W-2's and 1099's for interest income, dividends, capital gains, and retirement account activity. To avoid this problem it is always best to include copies of ALL W-2s and 1099s when preparing your return, even if there were offsetting expenses or a simple "rollover" of funds.
Don't panic if you receive a notice from the IRS, but don't ignore it. Review the notice and request assistance from your tax professional. It is often the case that the IRS can be satisfied by timely response and substantiation of a questioned item from your tax return.
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