Your tax return is due sometime in the next couple of weeks—unless you extend. And given that, I thought it’d make sense to talk about IRS audit prevention.
Don’t worry. We’re not going to dig down into the details of tax accounting or tax law. The discussion that follows focuses on the big picture stuff.
IRS Audit Prevention Tip #1: Don’t Rush to File Your Return
My first tip? Don’t rush to file a return. Rushing a return jacks your mistakes. And those errors will tend to increase your risk of an audit.
Note: You can extend your tax return for free as described here: how to extend your tax return.
IRS Audit Prevention Tip #2: Don’t Do Your Return by Hand
A second easy tip: Oh my gosh, please, please, don’t do your tax return by hand.
I know, I know. Some people proudly do prepare their tax returns by hand. But you don’t want to go “manual.”
Preparing your return by hand invariably means you make more errors. Again, more errors probably jacks up the “hey this return looks suspicious” score the IRS computers assign to your return.
Use a computer and tax preparation software to prepare your return. That’s the way to go.
IRS Audit Prevention Tip #3: Do E-file Your Return
By the way? You can file your tax return by mailing in a paper return or electronically.
But file electronically. Your return goes through extra error diagnostics when you file electronically. And those diagnostics also dial down errors and presumably the risks of the IRS contacting you about goofy stuff in your return.
IRS Audit Prevention Tip #4: Upgrade Your Preparer
Based on this assumption that return errors do increase your IRS audit risk, you may want to upgrade your preparer if you’re concerned about an audit.
A volunteer preparer will probably do a better job than you do (if only because this person will prepare many more returns than you do and probably will have an on-site expert he or she can consult).
A paid preparer will probably do a better job than an unpaid preparer. (This person earns a living preparing taxes, afterall.)
Finally, an enrolled agent or CPA who specializes in taxes will probably do a better job than an unenrolled preparer. (These people get lots of training and must continue to maintain their skills through professional education.)
Note: Good granular data on preparer errors is harder to come by than you might guess. But the IRS provides an interesting study here.
IRS Audit Prevention Tip #5: Use the Organizer
If you do outsource your tax return preparation to a paid preparer, she or he will surely provide you with either a paper or electronic organizer. This organizer includes checklists and simple worksheets you fill in to describe your financial year.
You really want to use the organizer. If you don’t, you’ll force the preparer to spend time teasing out the information in phone calls, emails and telephone conversations. (That wastes the preparer’s time organizing your data when the time should instead be spent preparing the actual tax return.)
Further, if you blow off the organizer, you’re very likely to omit some disclosure or bit of tax return information that’s really dangerous to omit. (The big example here? Omitting to tell IRS about foreign bank accounts and business holdings.)
IRS Audit Prevention Tip #6: Religiously Match 1099s, K-1s and W-2s
Another tip: Be sure your return matches the 1099 information returns that you and the IRS and state tax agencies receive.
For example, if you receive a 1099-MISC form reporting $10,000 of independent contractor income, be sure that income appears on your return.
Ditto for W-2s, of course! And ditto for K-1s you receive from partnerships, trusts, estates and S corporations.
By the way? Be particularly careful about 1099-Ks which show credit card payments you’ve received if you’re a small business. These 1099s can include amounts that you would not think to include as income like state sales tax, restaurant employee tips, and the credit card service fee collected by the bank before you even see any money.
IRS Audit Prevention Tip #7: Use a Real Accounting System
If your tax return includes rental property or a small business, you want to use a real accounting system. Something like QuickBooks or Xero or Quicken.
You don’t want to use a shoe box. Or Microsoft Excel. Or rely only on bank statements.
Without an accounting system, your income and expense data will end up sketchy. If you end up throwing rough estimates onto your return, for example, the numbers themselves will look suspicious. And the IRS computers seem to do a pretty good job identifying returns with sketchy or suspicious numbers.
IRS Audit Prevention Tip #8: Minimize your Multi-state Footprint
Each state in which you earn income probably expects a tax return from you.
And, in general, the only time you won’t owe that other state a tax return and income taxes is when that state doesn’t have an income tax.
But think about what this means. Each state in which you file a tax return has its own version of the Internal Revenue Service, of course. And in a sense, every tax return you file works like a lottery ticket where the “prize” is an audit.
Note: You “lose” the audit lottery by having your tax return selected for an audit because of errors or suspicious data or just because of random bad luck.
Accordingly, you may want to try to dial down the number of states in which you file tax returns and inadvertently “play” the audit lottery.
Furthermore, avoid investments (like partnerships) that mean you find yourself subject to taxes in scads of other states. (An investment in a pipeline partnership where the pipeline goes through ten states may saddle you with ten nonresident state tax returns.)
And don’t carelessly trigger filing requirements in other states by having a business presence in that other state: an employee of your small business, rental property, business operations and so forth.
IRS Audit Prevention Tip #9: Don’t Operate as a Sole Proprietorship
One final tip comes from the blog post the FiveThirtyEight news blog did a couple of weeks ago: Everyone Tries to Dodge the Tax Man.
That article provides lots of interesting bits of tax trivia—mostly about how people cheat on their taxes.
But something else interesting are the under-reported income statistics highlighted. It turns out that partnerships and S corporations under-report their income far less often than sole proprietorships.
That would suggest to me that operating as a partnership or S corporation very possibly dials down your audit risks… if only because you’re probably more likely to be considered “innocent by association.”