A tax audit may the the one thing that taxpayers hate more than paying taxes. Tax forms can be confusing, particularly if the taxpayer has a lot of deductions, but the risk of a tax audit means that it's worth spending a little bit of extra time making sure that no mistakes are made.
Here are five common mistakes made by taxpayers that could raise red flags for the IRS and result in a tax audit.
1. Income errors
Every business that pays out income sends copies of W-2s and 1099s to the IRS, and those copies are matched up against the income you report on your tax return form. Although it would seem pretty hard for a taxpayer to fail to report all of their income, there are a number of reasons why this could happen. For example, writers often get paid by multiple publishers throughout the course of the year, and that could make it easier to overlook a payment, misplace a 1099, or fail to realize that a 1099 was never received. People can also incorrectly record the amount of their income from their W-2 or 1099 on their tax forms.
If you work for one employer and only receive one W-2, it's unlikely you'll run this audit risk, but if you're a freelancer, make sure every penny earned is accounted for on your return and then triple-check the amounts you've entered on the income lines to make sure they're correct.
2. Total itemized deductions that are out of whack
A tax return could also be called into question if reported income appears to be too low relative to the amount of deductions claimed by the taxpayer. For example, someone reporting $50,000 in income and claiming a $30,000 mortgage interest deduction may pique the agency's interest.
Curious how much people typically claim in deductions relative to their earnings? Check out this table of 2011 data from the Congressional Research Service.
3. Wining and dining friends and family -- and then claiming a deduction for it
The majority of the money claimed in itemized deductions comes from mortgage interest and property tax payments, but the IRS will also dig deeper into miscellaneous deductions, and if something appears irregular, that could prompt an inquiry as well.
For example, if you pay to entertain your clients, save your receipts and take your deduction, but be aware that exceptionally large deductions for meals, entertainment, and travel could prompt the IRS to dig deeper. How large is too large is part of the IRS' secret sauce, but given that the IRS has years of data culled from millions of returns, its probably a good bet that IRS agents have a pretty good idea of what you can and cannot afford to spend on food and drink. As a result, make sure that your meals, entertainment, and travel deductions are for closing deals, not weekly grocery store trips for the family.
4. Taking road trips with the company car
Writing off a vehicle can be a nice tax benefit, but only if you do it correctly. Vehicles can be depreciated based on the percentage of time the vehicle is used for business. However, trying to claim 100% business use for a vehicle may furrow brows at the IRS -- particularly if there isn't another car in the household. Taxpayers should keep detailed logs of miles driven for work and the reasons for that travel so that they can claim the correct percentage of business use. That means you may want to think twice before packing family and friends into the company car for that beach trip you're planning.
5. Deducting your hobby
If you like to sail boats, go deep-sea fishing, breed horses, or race cars in your spare time, don't try to convince the IRS that the costs associated with boats, racing bits, or dragsters are deductible. The IRS has seen all of these situations pop up in the past, and the track record for taxpayers successfully lobbying the IRS to grant those deductions isn't great. In order to pass the IRS' sniff test, the activity must be run like a business, with a goal of profitability. An ongoing string of losses or an expensive activity that isn't likely to ever produce a profit won't cut it.
And another thing
The amount of money that taxpayers save by itemizing can be significant, but the IRS knows that itemizing creates significant opportunities for taxpayers to make mistakes. As a result, it's probably not too surprising to learn that while the IRS audits less than 1% of low-income earners, who typically claim the standard deduction, the IRS audits more than 2% of income tax returns filed by those earning more than $200,000, who typically itemize their deductions.
If you itemize, consider your totals against the average itemized deductions for similar income-earners before you file. If your numbers are vastly different from the numbers in the following table, go back and double-check your calculations and make sure you have all the proper supporting documentation.
Overall, the most important thing to remember is that the IRS isn't interested in people who are telling the truth; it only raises an eyebrow at those who seem to be inflating their deductions. So long as taxpayers maintain records proving their deductions are spot-on, there's little need to worry about an IRS tax audit.