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What triggers an IRS audit?

A plain vanilla return is usually safer than one that stands out. But if you have deductions that are above average, it's OK to take them.

By MSN Money Partner Apr 8, 2013 1:14PM

This post is by Kay Bell at Bankrate.com.

 

(© Mike Kemp/Rubberball/Getty Images)It is the most dreaded letter a taxpayer can receive.

 

Dear Taxpayer,

Some of the information that you provided to us does not agree with the information we received from other sources.

 The Internal Revenue Service

 

You've just joined an elite club, one whose initiation ritual is an IRS audit.

 

Unfortunately, you can't refuse membership — and the dues could be astronomical.

 

When the IRS Restructuring and Reform Act was enacted in 1998, lawmakers ordered the agency to focus more on taxpayer rights instead of collection activities. Not surprisingly, the number of audits — or examinations, as the agency prefers to call them — dropped dramatically.

The first year of the kinder, gentler IRS, about 1 in 79 tax returns was audited. By 2003, it was even easier for tax scofflaws; that year, according to IRS data, only 1 in 150 individual taxpayers was audited.

 

But the tax times, they are a-changing.

 

More audit attention

During the recent recession, the IRS implemented programs designed to take into consideration the financial struggles that many taxpayers encountered.

 

But balance doesn't mean taxpayers are off the hook. Facing pressure from a Congress dealing with a growing federal deficit, the IRS has made it clear it takes the enforcement portion of its job seriously.

 

Still, the IRS examined about 1% of all individual income tax returns during fiscal year 2012, according to the agency's 2012 annual data book (the latest edition available). Of that number, says the IRS, individual income tax returns reporting higher adjusted gross incomes were more likely to be examined.

 

But the rich aren't the only targets. Recent tax law changes, particularly when it comes to confusing tax breaks such as the first-time homebuyer credit, always prompt closer looks at returns. And if you're a small-business person, either as a partnership or a Schedule C filer reporting self-employment income on your personal tax return, make sure you take extra care with your returns.

 

Those with lower incomes that make them eligible for the complicated earned income tax credit, or EITC, also face added scrutiny. The IRS' latest data show that it audited 2.1% of returns by filers reporting less than $25,000 in income and who claimed this tax credit.

 

What's the DIF?

When it comes to avoiding prying IRS eyes, it's best to be just one of the crowd. "Don't draw any more attention to your return than you need to," says Robert G. Nath, author of "The Unofficial Guide to Dealing with the IRS." "Simple, plain-vanilla returns are fairly safe."

 

The IRS says there are several ways a return can be selected for audit and the first is via the agency's computer-scoring system known as Discriminant Information Function, or DIF. The IRS evaluates tax returns based on IRS formulas, and DIF is based on deductions, credits and exemptions with norms for taxpayers in each of the income brackets.

 

The actual scoring formula to determine which tax returns are most likely to be in error is a closely guarded secret. But Nath, a tax attorney in the Washington, D.C., area, says it's no mystery the system is designed to screen for returns that could put more money in the government Treasury.

 

How do your deductions compare?

Tax experts believe one discriminant information function component looks at average deduction amounts. This allows IRS examiners to spot inconsistencies, such as a high mortgage interest deduction and low income.

 

Tax specialists at CCH examined 2010 return statistics, the latest complete data, and came up with these itemized deduction averages. These are for illustrative purposes only. CCH experts note that the IRS takes a dim view of taxpayers who base their claimed deductions on these figures. The numbers can be useful, however, in giving you a general idea as to whether certain deductions on your return might seem out of line.

 

Allison Einbinder, owner of Dollars & Sense, a tax and accounting firm in Oakland, Calif., recommends that all filers review the differential comparisons. How you stack up against a national standard, she says, will give you an idea of whether the IRS might take a closer look at your return.

 

So what is likely to trigger a discriminant information function red flag?

  • Higher incomes.
  • Income other than basic wages; for example, contract payments.
  • Unreported income, such as investment returns.
  • Home-based businesses, especially when in addition to salary income, and home-office deductions.
  • Noncash charitable deductions.
  • Large business meal and entertainment deductions.
  • Excessive business auto usage.
  • Losses from an activity that could be viewed as a hobby rather than a business.
  • Large casualty losses.

Returns claiming the earned income tax credit, designed as a tax break for lower-income wage earners, also catch IRS eyes. The credit's complexity often results in legitimate mistakes on returns. Some filers, however, have been caught making false claims to increase the payment the credit provides.

 

Schedule C filers who report a business loss also are likely to face more questions from the IRS. The agency wants to be sure that it was indeed the economy, and not an effort to trim taxes, that produced the bad business results.

 

Don't cheat yourself

But don't let fear of a potential audit discourage you from filing for tax credits or taking legitimate tax deductions.

 

Although some tax return actions are likely to flag your return, Nath says that doesn't necessarily mean you'll be audited.

 

Even if your return is questioned, it's not a foregone conclusion that you'll end up owing the IRS. As long as your deductions and expenses are legitimate and you have documentation, Nath says, they will be allowed.

 

The groundwork you put into preparing your return will pay off in an audit situation. "

 

"Be confident in what you entered," says Einbinder. "That's easy when you have good records to support your tax return entries."

 

And even if an audit doesn't go your way, don't despair. "You have rights to contest audits," Nath says, "at every level of the process."

 

More from Bankrate.com and MSN Money:

VIDEO ON MSN MONEY

78Comments
Apr 8, 2013 4:00PM
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Flat tax would solve many of today's corruptions, sins and tax issues....
Apr 8, 2013 3:01PM
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I thought the trigger was having any money left
Apr 8, 2013 3:08PM
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The IRS is only the tax collector.  They don't make the laws that rob you and me.  The real culprits are CON-gress.  And CON-gress has a sure fire plan to keep them in office!  Make sure the percentage paying the taxes is lower than the percentage not paying taxes.  This year, I think that ratio was 47% paying taxes to 53% not paying taxes.  So, the 53% will keep the crooks in office.  There is one way and only one way to get the 535 clowns out of office.  The future of Bullymerica lies not in the hands of the voters but in the hands of those paying taxes.  IF all paying taxes would simply BALK, walk off their jobs and go home, then something would have to change.  The problem is DEDICATION.  American workers are dedicated to their work and therefore would be reluctant to walk off.  But, when the load gets too heavy, they might.  Then, the freeloaders would have to work, work more or go hungry.  That would get the clowns out of office!!!  Until then, expect taxes to increase and times to get harder.
Apr 8, 2013 3:05PM
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Now that Obama is hiring 16,000 additional IRS agents and staff for the PPACA, I'd be willing to wager we'll see many many more tax audits as The Federal Takeover Movement peers closer and closer into our lives.
Apr 9, 2013 1:13AM
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Why are the people who are paying taxes getting audited when the people who pay no taxes getting a free ride?
Apr 8, 2013 2:53PM
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Another trigger - I signed a petition asking for the resignation of Eric Holder because of Fast and Furious, a month later I was being audited by the IRS - Just a coincidence?

Apr 8, 2013 4:19PM
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I wonder when our government employees will pay their taxes?
Apr 8, 2013 5:18PM
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FLAT TAX is the answer, but it will never happen. The CPA/TurboTax /H&R Block lobby has the politicians in its back pocket
Apr 9, 2013 5:38AM
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I am writing out a check this week to the IRS for my Federal taxes - $5,600!  I will send another $1,600 to my state for income taxes.  Additionally, I was required by Obamacare to pay $14,000 in health insurance premiums, co-pays and deductibles.  Have working Americans put in 50 hour weeks, only to have a third or more of your income go to taxes and health insurance is outrageously ridiculous.  My 13-year old's health insurance premium is no $6,000 a year!  The out-of-pocket for his insurance is $9,700.  Not even medicine is covered until we reach $5,700 a year.  It was not always like this.  Just 4 years ago my dependent premium was $78 month.  Remember now, that $6K a year is just for my kid!  I still have to get insurance and my wife too!  My kid's public school teacher has not paid $6000 TOTAL for her own insurance in the 20 years she has been working!  Americans are obviously being ripped off.  Oh, to all you libs reading this: Obamacare also put the giant kabosh to an insurance market for kids in my state - NO OPTIONS FOR KIDS! 
Apr 8, 2013 5:04PM
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Yeah?  BeingHonest080312 wants you to walk away from your job?  I bet he won't put his foot forward where his mouth has been.  I wouldn't ask anyone to walk away from their job.  How you going to live?  That only works if you have money in the bank.  The way I hear it, most of us don't get paid enough to save any money.  However, I did!  And I did walk away when I realized that I was working for all those free loaders out there, not just the needy, but the crooks, both Washington D.C. and mainstream America.  So the government isn't getting the roughly $16,000/year in income tax from me anymore cause I don't work!  I won't work!  And as soon as I reach 62, I'm going to start taking my reduced social security benefit so that I can begin taking back all that money I've paid over the years for retirement insurance which they now trying tell me is an entitlement!  Of course, the government doesn't miss my contribution.  Instead, they just borrow more.    The bottom line is that all you chumps still working have been left holding the bag so the rest of us can feed for free!
Apr 8, 2013 3:07PM
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how about:  Dear Taxpayer: How come you have not filed income tax returns in x # of years even though you should based on your income. 
Apr 8, 2013 10:53PM
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I agree. A flat tax would simplify everything and help put all these tax attorneys and tax preprarers out of business.
Apr 8, 2013 6:22PM
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The letter described at the beginning of the article is NOT an audit request letter.  It is a very common letter just asking for additional information to clear up a discrepancy.  In most, I would say in about 99% of the cases involving such a letter, the answer to the inquiry ends the inquiry and no further action is taken.  There is no audit.

 

If you get a letter that starts off with, Dear taxpayer, your return has been selected for examination, then you have an audit.

 

Of course based upon other articles and comments by MSN and its reporters, I would not expect total accuracy.

Apr 8, 2013 6:56PM
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23 billion in profits GTE paid no taxes IRS and the government are a fraud if you can cheat theme do it there is no moral crime from stealing from a thief that would be the US government and IRS they go hand in hand
Apr 8, 2013 7:53PM
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As the liberals are so fond of saying, "Lean forward"!
Apr 9, 2013 4:01AM
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quit trying to be creative and keep good records and if your audited you wont have any problems.

 

Apr 9, 2013 9:51AM
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Finally - a tax-related story actually worth the space it consumes.  Now if you would just expose these predators who advertize they will get the "IRS off your back."  I laugh at the one where the woman says that a lady from the IRS came to her door and told her she owed $72,000 in taxes!  Like that is how the IRS operates!  These predators cannot do anything for you that you could not do BETTER yourself.  TALK to the IRS YOURSELF.  You will be surprised at the results - and the THOUSANDS OF DOLLARS you won't be paying the predators who claim they can work miracles for you.
Apr 9, 2013 9:49AM
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you left off a big one:  if the tax preparer you're using has a "history", or has another client getting an audit from HIS office, then there's a bigger chance of the IRS also looking at other returns prepared by HIS office. 
Apr 9, 2013 9:40AM
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It's all about votes people... WAK E up.   Class warfare is a destraction from the truth.
Apr 9, 2013 8:48AM
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