Audits by the IRS are most taxpayers' worst nightmares. While the likelihood of an audit is less than 1%, and only 0.86% of U.S. taxpayers were audited last year, there are certain factors that significantly raise your chances of an audit. Read on for the three biggest reasons the IRS could audit you.
IRS audit process
Although audits are a hassle, they're not as bad as they're made out to be. Generally, the IRS sends a letter about particular items on your tax returns, requests supporting documents or asks about a math error it thinks it has found, and proposes a correction and an amount due either from you or from the IRS.
The audit letter will contain a full explanation of the questionable part of your return, an explanation of the applicable tax rules, the next steps to take, and a response form. If you did your taxes correctly, you can either provide supporting documentation or tell the IRS why you think you're in the right. If you did your taxes incorrectly, you can simply agree to the corrections or appeal their proposal.
The IRS invests millions of dollars each year in technology that sifts through tax returns looking for errors and inconsistencies. And even if you think you did your taxes correctly, there are certain factors that greatly increase the odds that the IRS will audit you. Let's go over some of the biggest red flags.
1. Underreporting income
The IRS received 2.3 billion third-party tax returns for taxpayers in 2014. These are the W-2s and 1099s filed by employers and other payers to let the IRS know how much they paid and to whom. The IRS takes all this information and matches it with your tax returns. If a third-party filed tax information on you to the IRS, and you then failed to report that when you filed your taxes, you will likely receive a letter from the IRS' Automated Underreporter Program. This program sends letters to taxpayers when it finds a discrepancy between their tax returns and the third-party information. The IRS sent out 3.8 million such letters for tax year 2013 and collected $5.9 billion in additional taxes from them.
2. Math errors
The second-biggest audit risk is a math error. In 2013, the IRS sent 1.7 million letters to taxpayers regarding math errors. The three biggest sources of math errors in 2013 were:
- The number or amount of exemptions taken (14.3% of math errors)
- Problems with standard or itemized deductions (12.3% of math errors)
- Earned income tax credit (11.3% of math errors)
I highly recommend you file electronically -- and the IRS agrees. As the IRS recently wrote: "Filing electronically, whether through e-file or IRS Free File, vastly reduces tax return errors, as the tax software does the calculations, flags common errors and prompts taxpayers for missing information. And best of all, there is a free option for everyone."
3. High income
The biggest factor for many people who get audited is their income level. Based on the 2013 tax year's data, the 84% of taxpayers with adjusted gross incomes between $1 and $200,000 have less than a 0.7% chance of being audited. That means only about one out of every 150 people in this income level will be audited.
As your adjusted gross income grows beyond $200,000, the chance that you will be audited rises sharply. The only exception to this is at the other end of the spectrum; if you report negative adjusted gross income, you then have about a 5% chance of being audited. Below are the odds that you'll be audited based on your adjusted gross income, based on 2013 tax year data.
There are two reasons for this. First, people with higher incomes tend to have more complicated taxes, so the chance of an error goes up. Second, the IRS has limited resources, so its directs more manpower toward the highest-income returns, where it can get the most money back in the case of an error.
Protect yourself from audits
The best way to protect yourself from audits is to use a tax software program to file electronically and keep good records in case you do get audited.
Dan Dzombak is a long term investor and writes about happiness.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.