When taxpayers receive a tax audit notice, they often feel as if they are stranded on a hostile island and danger awaits. If their record keeping is shoddy or if they or their tax preparer engaged in dubious tax strategies, they are certainly correct.
Abraham Lincoln once said, “He who represents himself in court has a fool for a client.” The same reasoning applies to tax audits. You will want to have an enrolled agent, certified public accountant or attorney represent you.
A good tax preparer will coach you as he or she prepares your return each year as to what records need to be kept. Areas of specific scrutiny include business mileage, entertainment expense, charitable contributions and equipment purchases.
If self-employed, you have five times the chance of being audited versus the average taxpayer. You should have a separate business bank account. The source of all deposits to bank accounts needs to be documented because they will be scrutinized in a field audit.
While many individual items can trigger an audit, usually it’s a combination of several factors that cause your return to be selected.
Pretending a money-losing pastime is a business can cause it to be considered a hobby whereby only expenses are allowed to offset income, but you are not allowed to take a loss. Hobby businesses are a frequent audit target.
Using rounded numbers looks as if the taxpayer is guessing at expenses and raises suspicions.
Cancellation of debt income is an item individuals often misreport or ignore altogether. This is a complex area where you want a professional to properly report it and use an exclusion, if applicable.
You are allowed to claim the mortgage interest deduction on only $100,000 of home-equity debt, such as debt secured by your home but not used to buy or improve it. The IRS is aggressively conducting correspondence audits on taxpayers with high mortgage interest.
The best defense in an audit is good record keeping before the return is even prepared. Our tax laws are complex, even Treasury Secretary Timothy Geithner was found to have mistakes on his return when nominated.
When having your return done this year, ask your preparer for advice on record keeping and areas the IRS is most sensitive about.