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Don't Let Audit Fears Cost You Money

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The ides of March proved to be Caesar's downfall. But for the rest of us, the ides of April bring an even bigger sense of dread and foreboding.

Nobody likes to pay taxes, and no matter how much the bottom line on your 1040 is, you'll always wish it were lower. Yet for a number of reasons, many people pay more in income tax than they need to.

Some deliberately have too much money taken out of their paychecks, so they'll get a big refund check. Others miss out on savings amidst the complicated mix of deductions, credits, exclusions, and other arcane tax rules that are so hard for taxpayers to navigate.

But some people consciously choose not to claim certain deductions or credits that they're legally entitled to. Why? They think by not claiming them, they'll avoid getting audited.

The letter you never want to get
Sure, there's plenty to fear about an IRS audit. In the worst case scenario, the IRS may find some large item you forgot to include or incorrectly calculated, costing you not only extra tax but also potential interest and penalties on the unpaid amount. And even if you didn't make any mistakes and the IRS finds no reason to hike your tax bill, you'll still waste tons of time -- and often pay the substantial cost of hiring a CPA or tax attorney to help defend you against any alleged problems.

Given those fears, you may think it's worth a few bucks to avoid some of the red flags that raise your likelihood of getting audited. At some point, though, throwing away legitimate and completely legal chances to save on taxes becomes a losing strategy.

Businesses fight audits -- so can you
Keep in mind that individual taxpayers aren't the only ones who get audited. Large corporations often face challenges from the IRS about methods they use to cut or eliminate their tax liability. Yet that doesn't stop companies from pushing the limits of the tax laws to look for any loophole they can find.

For instance, Wells Fargo (NYSE: WFC  ) recently took advantage of a tax loophole to reap the benefits of billions in tax losses when it outbid Citigroup (NYSE: C  ) to buy out rival Wachovia. Similarly, companies like Transocean (NYSE: RIG  ) , Tyco International (NYSE: TYC  ) , and Halliburton (NYSE: HAL  ) have moved their corporate headquarters to foreign locations such as Switzerland and Dubai to try to forestall a crackdown on U.S. income taxes.

Sometimes, of course, companies get audited anyway. An initial victory for General Electric (NYSE: GE  ) on an alleged tax shelter turned into a failure when the company lost a tax case on appeal. But the IRS doesn't always win those cases. Several years ago, Black & Decker (NYSE: BDK  ) successfully collected $57 million in refunds from the IRS, saving the company from an estimated $140 million tax bill.

Deductions that interest the IRS
On your return, you may have heard that taking certain deductions makes you more likely to get audited. Deductions for things like self-employed business expenses and home office costs can raise red flags. In addition, unusually high amounts for otherwise legitimate deductions like charitable gifts and mortgage interest can draw the IRS' attention

Yet the best answer isn't just to give up on those deductions. Instead, take full advantage of them -- but realize that because you're raising your profile for a potential audit, you'll want to keep better records than usual. Make sure you understand exactly how the law works, and document the steps you took to figure out what numbers to put on your return. That way, if you have to explain it either to an IRS agent or to your own accountant or attorney, you'll be able to do so without panicking.

Taxes aren't any fun, so it doesn't make any sense to pay more than you have to. As long as you're doing the right thing, the specter of an IRS audit shouldn't keep you from getting every penny you're entitled to.

For more on saving taxes, read about:

Taxes are always on our mind at The Motley Fool's Rule Your Retirement newsletter. Get the latest in tax-saving strategies in each issue, along with investment advice and other useful information. Get full access free with a 30-day trial.

Fool contributor Dan Caplinger isn't done with his taxes yet this year, but he's getting close. He owns shares of General Electric. Tyco International is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't audit you.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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