According to IRS statistics, only about 1% of all tax returns are selected for audits. However, the difference in audit rates between certain groups can be substantial. In fact, some types of tax returns have audit rates as high as 17%.
Here are three groups that are at high risk of an audit, and what you can do to prepare yourself if you belong to one of these segments.
Group 1: High-income individuals
As a general rule of thumb, the more money you make, the higher the likelihood you'll be audited. According to the IRS Data Book, only 0.4% of taxpayers who earned less than $200,000 and didn't have business income in fiscal 2012 were selected for audit.
However, taxpayers who earned between $200,000 and $1 million had an eight times greater chance of an audit, or 3.2%. Those fortunate enough to have earned more than $1 million were audited more than 12% of the time.
There are several reasons for this. For one, high-income individuals are much more likely to itemize deductions rather than taking the standard deduction amount. Unusual itemized deductions can be a red flag.
Also, the IRS simply finds more value in auditing high earners. Just like any other agency, the IRS has to pay its employees to conduct an audit. So it wants to be reasonably confident the outcome of the audit will be more than the cost to conduct it. Makes sense, right? Well, errors on high-income tax returns tend to bring in more revenue than those of low-income taxpayers.
Group 2: Small business owners/self-employed individuals
If your return includes a Schedule C or E, which are used to report income from sole proprietorships, single-member LLCs, rental properties, and interests in trusts and partnerships, the chances of an audit increase significantly.
I already mentioned that taxpayers with less than $200,000 in annual income only have a 0.4% audit rate if they don't have any business income. However, once a schedule C or E is attached to their return, the likelihood of an audit triples to 1.2%. And if their business income is over $100,000 of the total, the audit rate rises to 3.5%.
The main reason more small business owners and self-employed individuals tend to get audited is they have access to more deductions. Some of these have a high incidence of "exaggeration," such as the deduction of business meals and entertainment expenses.
Group 3: Corporate tax returns
Corporations (other than sole proprietorships and single-member LLCs) that file a corporate tax return are a big target of the IRS, particularly those with sizable corporate assets. The reason is simple: corporations have more money than do individuals, and there is a greater likelihood that the audit will be worthwhile.
Corporations with less than $1 million in assets have an audit rate of just less than 1%, which is about the same as the overall average for individual returns. However, over that amount, the chance of an audit rises significantly. With assets of between $1 million and $10 million, the audit rate more than doubles to 2.1%. Corporations with more than $10 million in assets are a favorite group of the IRS, with a 17.2% audit rate. In other words, nearly one in six tax returns from corporations with more than $10 million in assets is selected for an audit.
General preparation for an audit
Even if you belong to one of these groups, an audit doesn't need to be a huge cause for concern. Most of the time, an audit is a pretty simple procedure in which the IRS requests that you verify an item or two on your tax return, and can even be handled entirely by mail. As long as you can document all of the information on your return, you should be just fine.
If you get selected for an office audit (in which you go to your local IRS office) or a field audit (in your home or business), as long as your tax return contains factual information you should have nothing to worry about. Usually these audits would simply be impractical to conduct through the mail -- for example, reviewing a corporation's books -- but shouldn't be much more than an inconvenience if you're prepared.
The bottom line is to be honest on your tax return and able to prove that you were honest. If you can do that, you shouldn't stress about the possibility of an audit. If you are in one of these groups, just be aware that there's a better chance it will happen to you, so be extra careful when preparing your return.