5 ways to avoid an audit

Whether you're facing an audit or simply want to avoid one, here are steps to take to deflect attention or get you prepared.

By Jeff Schnepper

Why me? You just got the invitation to a "party" that you hoped you'd never attend -- an IRS audit.

How did this happen and how can you prevent it from happening again? We'll get to the how when we answer how to minimize the chances of an audit and how to survive one.

Rule 1: Check your arithmetic

Few audits are generated by mathematical mistakes alone. The Internal Revenue Service computers automatically correct both mathematical errors and mistakes where you have claimed deductions that exceed limits set by the tax code itself, such as the 7.5% adjusted gross income limitation on medical deductions. However, too many of these kinds of errors indicate a sloppy return, and that could lead to a full audit.

While the advice may seem obvious, don't give the IRS any additional reasons to look at your return.

But how do you get picked?An IRS computer program compares your deductions to others in your income bracket and weighs the differences. This secret IRS formula, called the DIF Score, is used to select returns with the highest probability of generating additional audit revenue.

For example, a taxpayer with a $50,000 salary would rarely have $10,000 in charitable contributions. This doesn't mean that, if you have only $50,000 in income and actually have $10,000 in charitable contributions, you shouldn't claim those deductions. It only means that if that is the case, be prepared to prove those deductions. The DIF formula considers not only your income and deductions, but where you live, the size of your family and your profession as well. Rarely will a family of five living in the Hamptons have an income of $30,000 or less. It may happen, but if it does, the IRS will want to know how. This leads to . . .

Rule 2: Arrange your finances so they don't stand out

If you think you may be audited, see if your situation is likely to attract the tax man's attention. Here are groups that often do invite inquiries:
The self-employed If you are self-employed, you have more opportunity to either "hide" your income or "create" deductions by converting personal expenses into business expenses. If so, be prepared to substantiate your expenditures as deductible expenses. The IRS is aware of the myriad "business vehicles" that go away to college every September, and the probability of your being audited is enhanced.

Those who get their income in cash. The IRS has specific audit programs aimed at specific professions and occupations. Because they receive much of their income in cash, people who work in the gaming industry, waiters and even doctors are prime audit targets. The more cash you receive and the higher your income potential, the more likely the IRS is to find additional tax dollars by reviewing your return.

There are a number of areas of potential abuse that attract the IRS. In recent years, the IRS has been targeting these areas for audit:

Offshore credit card users

High-risk, high-income taxpayers

Investors in abusive schemes and promotions

High-income non-filers

Unreported income

Rule 3: Substantiate, substantiate, substantiate

In the audit itself, the IRS will focus on those items for which taxpayers have historically failed to keep the required substantiation. Traditionally, auto, travel, meals and entertainment have been the areas most audited. To deduct auto expenses, you must establish the percentage of business use as well as the actual expenses incurred. I ask my clients to keep a mini-cassette recorder in their cars to record the business mileage and purpose. Kept contemporaneously, it is acceptable as sufficient substantiation of business use. Alternatively, a written diary of miles used for business would also be accepted.

You must have a receipt for all expenditures of $75 or more for meals and entertainment. The rule is simple: no receipt, no deduction. If the expense is less than $75, a diary notation is sufficient. However, both the receipt and the diary notation must have all of the following information:

The amount paid

The name and location of the restaurant or entertainment facility

The person you entertained

That person's business relationship with you

The business discussion related to the entertainment

Unless you talk business, before, during or after the meal, your deduction won't be allowed. Remember, with the IRS, paper rules! With any and all expenses, deductions will be more easily allowed if you have a piece of paper to back them up.

Here's another piece of advice: Don't come in with a carton of miscellaneous receipts. The more "organized" your receipts and the more paper you produce, the easier it is for an IRS agent to conclude that you are organized, have full substantiation and owe no additional taxes.One more point about how you're selected for an audit. The IRS computer pulls out many returns for audit on a random basis. Your income, deductions or where you live are irrelevant. Your number just came up -- you won the audit lottery. A student making $3,000 a year is just as likely to be selected as an accountant making $300,000. You just got "lucky."

The IRS can audit you for three years after you file your return. In reality, however, most returns are audited within 18 months of filing. This gives the IRS time to do the review and request the appropriate substantiation before the statute of limitations (usually the three-year period) ends. Once the statute has run out, the IRS normally cannot audit your return, and your expenses are insulated from examination. It has been claimed that the later you file, the less likely it is the IRS will pick your return to be examined. The IRS still insists that agents are not graded or evaluated on the amount of money they collect until -- surprise! -- congressional testimony reveals that policy is not the same as practice.

Rule 4: Know when to file

I recommend that you have your return prepared early. If you have a big refund and are unconcerned with audit issues, file early and get your money back. If you have taxes due, and no penalty for underpayment, don't file until April 15. Don't ever pay a federal tax bill before it is due. It's an interest-free loan to the IRS.

On the other hand, if you are concerned about a potential audit, never file until the last minute. It won't hurt and can only decrease your chances of being selected.

Rule 5: Plan your taxes to pre-empt an audit

I highly recommend the use of pre-audit strategies. If, say, you have a huge medical deduction for a year that you feel would increase your chances of being audited, attach copies of your medical bills to your return.

Alternatively, if you made an unusually large charitable contribution, attach a copy of the check or receipts to your return. The IRS computer will still kick out your return, but when a real person looks at it, the reviewer will recognize that you know the rules. It may actually reduce your odds of a full audit.

Provided courtesy of http://articles.moneycentral.msn.com/

Tax Tips for the Unemployed

As April 15 approaches, those who were out of work in 2008 might have a lot of questions about their tax returns. Here are some answers.

By Jessica Dickler, CNNMoney.com staff writer
Last Updated: January 9, 2009: 3:39 PM ET

NEW YORK (CNNMoney.com) -- Tax season can be a frustrating and confusing time for those with a spotty employment record and little spare cash. But people who were out of work in 2008 will still have to report to Uncle Sam.

Friday's labor report showed that nearly 2.6 million jobs were lost over the course of 2008, the highest yearly job-loss total since 1945. The unemployment rate now stands at 7.2%, a 16-year high, according to the Labor Department.

"More people than ever before may be experiencing, for the first time, unemployment and the tax implications related to that," saidMark Steber, vice president of tax resources at Jackson Hewitt.

For those taxpayers who were unemployed in 2008 and unsure about how to account for a brutal year, here are some answers:

Do I still have to pay tax if I was out of work in 2008?

Probably. The IRS requires anyone who received a W2 from their employer and made at least $8,950 (if you're single and under 65 years old), or made at least $400 if you're self employed, to file a tax return. If you're anticipating a tax refund, you must file - even if you didn't work at all.

But whether you will have a tax liability depends on a variety of factors, Steber said. "Every tax situation is unique, based on the facts and circumstances of the taxpayer."

For example, if you only had unemployment compensation throughout the year, you may owe some tax on the checks you received. A severance package could also give you a tax bill, as could dividends and interest from investment income.

Other factors that weigh in include your tax deductions and other life changes associated with unemployment, like if you downsized your house or picked up supplemental income, Steber said.

Do I have to pay tax on my unemployment checks?

Yes. Unemployment compensation is taxable on federal and most state tax returns.

When applying for unemployment, you can choose whether you want federal and/or state income taxes automatically taken out of your unemployment benefits. If you choose to withhold, federal income taxes are withheld at a 10% rate, while the state rate varies. But since many cash-strapped Americans opt not to withhold - come April they may have to pay up.

So unless you previously elected to have taxes withheld throughout the year from your unemployment checks, a tax bill may be an unwelcome surprise when you file your 2008 return.

What if I took money from my 401(k)?

You may owe taxes if you took money out of a retirement plan or 401(k) to supplement your unemployment checks. That counts as income and is taxable too, said Joseph Perry, the partner in charge of Marcum & Kliegman's tax department. And that might not be all you owe. The taxes are in addition to a 10% penalty on early withdrawals if you're below the age of 59-1/2, he cautioned.

What if I did some supplemental work?

Freelance and project work can be a lifeline for unemployed workers between jobs. "Unemployed tend to become self-employed, that's a natural outgrowth of being unemployed," Steber said.

But if you picked up odd jobs or offered consulting services while unemployed, you're subject to income tax and self-employment tax on that income.

To report that supplemental work, taxpayers must include a Schedule C with their income tax return, which details the income and expenses for the year.

If you continued a project for your old employer or freelanced for someone else, and made more than $600, you will be issued a 1099 and must include that in your income tax return as well. (If you made less than $600, then you will not be issued a 1099 but are still responsible for reporting anything you made as taxable income.)

What if I had to relocate for a job?

If you accepted a new job that required relocating, you may also be able to deduct the moving expenses not reimbursed by your new employer. But there's a catch, the new job site has to be 50 miles further than the old residence was from the old job, according to Tom Ochsenschlager, vice president of taxation for the American Institute of Certified Public Accountants, which basically prevents you from trying to deduct a move within the same metropolitan area.

What if I spent a lot of money on job searches?

Those who were on the job hunt last year may get a gift from Uncle Sam: a slew of tax deductions. In fact, many of the expenses incurred while looking for a job can be deducted, which can result in some serious savings.

By declaring the following itemized deductions, taxpayers may lower the amount of taxable income they have for the year.

For starters, anything you spend on creating, printing and mailing your resume is deductible, as is anything you spend on a career coach or headhunter. Also included are long distance or cell phone charges directly associated with your job search.

Transportation costs such as a bus, taxi, train or plane to an interview is deductible, as is the mileage costs accrued when you drive to interviews and even to the unemployment office. (Between Jan. 1, 2008, and June 30, 2008, taxpayers can claim 50.5 cents per mile, between July 1, 2008 and Dec. 31, 2008, taxpayers can claim 58.5 cents per mile.) That also goes for parking and tolls and meals and lodging if the interview was out of town.

But the buck stops there. You cannot, unfortunately, deduct the value of your time or the cost of a new interview suit, briefcase or new shoes for pounding the pavement.

Of course, taxpayers should keep receipts related to any of these expenses in order to substantiate them when filing and experts recommend consulting a professional tax preparer for help.

First Published: January 9, 2009: 2:43 PM ET